HORIZON BANCORP
FORM 10-Q
United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014
Commission file number 0-10792
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
Registrant’s telephone number, including area code: (219) 879-0211
Former name, former address and former fiscal year, if changed since last report: N/A
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” 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). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 9,210,786 shares of Common Stock, no par value, at November 7, 2014.
INDEX
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets
Condensed Consolidated Statements of Income
Condensed Consolidated Statements of Comprehensive Income (Loss)
Condensed Consolidated Statement of Stockholders’ Equity
Condensed Consolidated Statements of Cash Flows
Notes to Condensed Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Signatures
Index To Exhibits
2
PART 1 — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HORIZON BANCORP AND SUBSIDIARIES
(Dollar Amounts in Thousands)
Assets
Cash and due from banks
Investment securities, available for sale
Investment securities, held to maturity (fair value of $175,838 and $9,910)
Loans held for sale
Loans, net of allowance for loan losses of $16,160 and $15,992
Premises and equipment, net
Federal Reserve and Federal Home Loan Bank stock
Goodwill
Other intangible assets
Interest receivable
Cash value life insurance
Other assets
Total assets
Liabilities
Deposits
Non-interest bearing
Interest bearing
Total deposits
Borrowings
Subordinated debentures
Interest payable
Other liabilities
Total liabilities
Commitments and contingent liabilities
Stockholders’ Equity
Preferred stock, Authorized, 1,000,000 shares Series B shares $.01 par value, $1,000 liquidation value Issued 12,500 shares
Common stock, no par value Authorized, 22,500,000 shares Issued, 9,280,041 and 8,706,971 shares Outstanding, 9,210,786 and 8,630,966 shares
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income (loss)
Total stockholders’ equity
Total liabilities and stockholders’ equity
See notes to condensed consolidated financial statements
3
(Dollar Amounts in Thousands, Except Per Share Data)
Interest Income
Loans receivable
Investment securities
Taxable
Tax exempt
Total interest income
Interest Expense
Borrowed funds
Total interest expense
Net Interest Income
Provision for loan losses
Net Interest Income after Provision for Loan Losses
Non-interest Income
Service charges on deposit accounts
Wire transfer fees
Interchange fees
Fiduciary activities
Gain on sale of investment securities (includes $988 for the three and nine months ended September 30, 2014 and $6 for the three months ended and $374 for the nine months ended September 30, 2013, related to accumulated other comprehensive earnings reclassifications)
Gain on sale of mortgage loans
Mortgage servicing income net of impairment
Increase in cash value of bank owned life insurance
Other income
Total non-interest income
Non-interest Expense
Salaries and employee benefits
Net occupancy expenses
Data processing
Professional fees
Outside services and consultants
Loan expense
FDIC insurance expense
Other losses
Other expense
Total non-interest expense
Income Before Income Tax
Income tax expense (includes $346 for the three and nine months ended September 30, 2014 and $2 for the three months ended and $131 for the nine months ended September 30, 2013 related to income tax expense from reclassification items)
Net Income
Preferred stock dividend and discount accretion
Net Income Available to Common Shareholders
Basic Earnings Per Share
Diluted Earnings Per Share
4
Condensed Consolidated Statements of Comprehensive Income
Other Comprehensive Income
Change in fair value of derivative instruments:
Change in fair value of derivative instruments for the period
Income tax effect
Changes from derivative instruments
Change in securities available-for-sale:
Unrealized appreciation (depreciation) for the period on available-for-sale securities
Unrealized appreciation for the period onheld-to-maturity (1)
Reclassification adjustment for securities gains realized in income
Unrealized gains (losses) on available-for-sale securities
Other Comprehensive Income (Loss), Net of Tax
Comprehensive Income
5
HORIZON BANCORP ANDSUBSIDIARIES
(Unaudited)
Balances, January 1, 2014
Net income
Other comprehensive income, net of tax
Amortization of unearned compensation
Exercise of stock options
Stock option expense
Stock issued from acquisition
Cash dividends on preferred stock (1.00%)
Cash dividends on common stock ($.37 per share)
Balances, September 30, 2014
6
Operating Activities
Items not requiring (providing) cash
Depreciation and amortization
Share based compensation
Mortgage servicing rights recovery
Premium amortization on securities available for sale, net
Gain on sale of investment securities
Proceeds from sales of loans
Loans originated for sale
Change in cash value of life insurance
Gain on sale of other real estate owned
Net change in
Net cash provided by operating activities
Investing Activities
Purchases of securities available for sale
Proceeds from sales, maturities, calls, and principal repayments of securities available for sale
Purchase of securities held to maturity
Proceeds from maturities of securities held to maturity
Purchase of Federal Reserve Bank stock
Net change in loans
Proceeds on the sale of OREO and repossessed assets
Purchases of premises and equipment
Acquisition of SCB
Purchase of Mortgage Company
Net cash provided by (used in) by investing activities
Financing Activities
Proceeds from issuance of stock
Dividends paid on common shares
Dividends paid on preferred shares
Net cash provided by (used in) financing activities
Net Change in Cash and Cash Equivalents
Cash and Cash Equivalents, Beginning of Period
Cash and Cash Equivalents, End of Period
Additional Supplemental Information
Interest paid
Income taxes paid
Transfer of loans to other real estate owned
Transfer of available-for-sale securities to held-to-maturity
The Company purchased all of the capital stock of Summit for $18,896. In conjunction with the acquisition, liabilities were assumed as follows:
Fair value of assets acquired
Cash paid to retire Summit debt
Cash paid for the capital stock
Liabilities assumed
7
(Table Dollar Amounts in Thousands, Except Per Share Data)
Note 1 - Accounting Policies
The accompanying unaudited condensed consolidated financial statements include the accounts of Horizon Bancorp (“Horizon” or the “Company”) and its wholly-owned subsidiaries, including Horizon Bank, N.A. (“Bank”). All inter-company balances and transactions have been eliminated. The results of operations for the periods ended September 30, 2014 are not necessarily indicative of the operating results for the full year of 2014. The accompanying unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of Horizon’s management, necessary to fairly present the financial position, results of operations and cash flows of Horizon for the periods presented. Those adjustments consist only of normal recurring adjustments.
Certain information and note disclosures normally included in Horizon’s annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in Horizon’s Annual Report on Form 10-K for 2013 filed with the Securities and Exchange Commission on February 28, 2014. The condensed consolidated balance sheet of Horizon as of December 31, 2013 has been derived from the audited balance sheet as of that date.
Basic earnings per share is computed by dividing net income available to common shareholders (net income less dividend requirements for preferred stock and accretion of preferred stock discount) by the weighted-average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The following table shows computation of basic and diluted earnings per share.
Basic earnings per share
Less: Preferred stock dividends and accretion of discount
Net income available to common shareholders
Weighted average common shares outstanding
Diluted earnings per share
Effect of dilutive securities:
Warrants
Restricted stock
Stock options
Weighted average shares outstanding
At September 30, 2014 and 2013, there were 46,766 and no shares, respectively, which were not included in the computation of diluted earnings per share because they were non-dilutive.
8
Horizon has share-based employee compensation plans, which are described in the notes to the financial statements included in the December 31, 2013 Annual Report on Form 10-K.
Reclassifications
Certain reclassifications have been made to the 2013 condensed consolidated financial statements to be comparable to 2014. These reclassifications had no effect on net income.
Note 2 – Acquisition
On April 3, 2014 Horizon closed its acquisition of SCB Bancorp, Inc. (“Summit”) and Horizon Bank N.A.’s acquisition of Summit Community Bank, through mergers effective as of that date. Under the final terms of the acquisition, the exchange ratio was 0.4904 shares of Horizon’s common stock and $5.15 in cash for each share of Summit common stock outstanding. Summit shares outstanding at the closing were 1,164,442, and the shares of Horizon common stock issued to Summit shareholders totaled 570,820. Horizon’s stock price was $22.23 per share at the close of business on April 3, 2014. Based upon these numbers, the total value of the consideration for the acquisition was $18.9 million (not including the retirement of Summit debt). For the nine months ended September 30, 2014, the Company had approximately $1.3 million in costs related to the acquisition. These expenses are classified in the other expense section of the income statement and primarily located in the salaries and employee benefits, professional services and other expense line items. As a result of the acquisition, the Company will have an opportunity to increase its deposit base and reduce transaction costs. The Company also expects to reduce cost through economies of scale.
Under the purchase method of accounting, the total estimated purchase price is allocated to Summit’s net tangible and intangible assets based on their current estimated fair values on the date of the acquisition. Based on management’s preliminary valuation of the fair value of tangible and intangible assets acquired and liabilities assumed, which are based on estimates and assumptions that are subject to change, the preliminary purchase price for the Summit acquisition is allocated as follows:
ASSETS
Commercial
Residential mortgage
Consumer
Total loans
FRB and FHLB stock
Core deposit intangible
Total assets purchased
Common shares issued
Cash paid
Retirement of Holding Company Debt
Total estimated purchase price
LIABILITIES
NOW accounts
Savings and money market
Certificates of deposits
Total liabilities assumed
9
Of the total estimated purchase price of $19.9 million, $822,000 has been allocated to core deposit intangible. Additionally, $8.3 million has been allocated to goodwill and $4.4 million of the purchase price is deductible and was assigned to the business assets. The core deposit intangible will be amortized over seven years on a straight line basis.
The Company acquired loans in the acquisition and the transferred loans had evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.
Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit impaired. Evidence of credit quality deterioration as of the purchase date may include information such as past-due and non-accrual status, borrower credit scores and recent loan-to-value percentages. Purchased credit-impaired loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality (ASC 310-30) and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for credit losses related to these loans is not carried over and recorded at the acquisition date. Management estimated the cash flows expected to be collected at acquisition using our internal risk models, which incorporate the estimate of current key assumptions, such as default rates, severity and prepayment speeds.
The Company acquired the $130.5 million loan portfolio at a fair value discount of $6.4 million. The performing portion of the portfolio, $106.2 million, had an estimated fair value of $104.6 million. The excess of expected cash flows above the fair value of the performing portion of loans will be accreted to interest income over the remaining lives of the loans in accordance with ASC 310-20.
Final estimates of certain loans, those for which specific credit-related deterioration, since origination, are recorded at fair value, reflecting the present value of the amounts expected to be collected. Income recognition of these loans is based on reasonable expectation about the timing and amount of cash flows to be collected.
The following table details the acquired loans that are accounted for in accordance with ASC 310-30 as of April 3, 2014.
Contractually required principal and interest at acquisition
Contractual cash flows not expected to be collected (nonaccretable differences)
Expected cash flows at acquisition
Interest component of expected cash flows (accretable discount)
Fair value of acquired loans accounted for under ASC 310-30
Pro-forma statements were not presented due to the materiality of the transaction.
10
Note 3 – Securities
The fair value of securities is as follows:
Available for sale
U.S. Treasury and federal agencies
State and municipal
Federal agency collateralized mortgage obligations
Federal agency mortgage-backed pools
Private labeled mortgage-backed pools
Corporate notes
Total available for sale investment securities
Held to maturity
Total held to maturity investment securities
Held to maturity, State and Municipal
Based on evaluation of available evidence, including recent changes in market interest rates, credit rating information, and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. While these securities are held in the available for sale portfolio and held-to-maturity, Horizon intends, and has the ability, to hold them until the earlier of a recovery in fair value or maturity.
Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified. At September 30, 2014, no individual investment security had an unrealized loss that was determined to be other-than-temporary.
The unrealized losses on the Company’s investments in securities of state and municipal governmental agencies, U.S. Treasury and federal agencies, federal agency collateralized mortgage obligations, and federal agency mortgage-backed pools were caused by interest rate volatility and not a decline in credit quality. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. The Company expects to recover the amortized cost basis over the term of the securities. Because the Company does not intend to sell the investments and it is not likely that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be at maturity, the Company did not consider those investments to be other-than-temporarily impaired at September 30, 2014.
11
The Company elected to transfer 319 available-for-sale (“AFS”) securities with an aggregate fair value of $167.1 million to a classification of held-to-maturity (“HTM”) on April 1, 2014. In accordance with FASB ASC 320-10-55-24, the transfer from AFS to HTM must be recorded at the fair value of the AFS securities at the time of transfer. The net unrealized holding gain of $1.3 million, net of tax, at the date of transfer was retained in accumulated other comprehensive income (loss), with the associated pre-tax amount retained in the carrying value of the HTM securities. Such amounts will be amortized to comprehensive income over the remaining life of the securities. The fair value of the transferred AFS securities became the book value of the HTM securities at April 1, 2014, with no unrealized gain or loss at this date. Future reporting periods, with potential changes in market value for these securities, would likely record an unrealized gain or loss for disclosure purposes.
The amortized cost and fair value of securities available for sale and held to maturity at September 30, 2014 and December 31, 2013, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Within one year
One to five years
Five to ten years
After ten years
12
The following table shows the gross unrealized losses and the fair value of the Company’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
Total temporarily impaired securities
Sales of securities available for sale (Unaudited)
Proceeds
Gross gains
Gross losses
Note 4 – Loans
Working capital and equipment
Real estate, including agriculture
Other
Total
Real estate
1–4 family
Auto
Recreation
Real estate/home improvement
Home equity
Unsecured
Mortgage warehouse
Allowance for loan losses
Loans, net
13
Commercial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected, and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
Commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves larger loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s commercial real estate portfolio are diverse in terms of property type, and are monitored for concentrations of credit. The Company monitors and evaluates commercial real estate loans based on collateral, cash flow and risk grade criteria. As a general rule, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.
Real Estate and Consumer
With respect to residential loans that are secured by 1-4 family residences and are generally owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.
Mortgage Warehousing
Horizon’s mortgage warehouse lending has specific mortgage companies as customers of Horizon Bank. Individual mortgage loans originated by these mortgage companies are funded as a secured borrowing with a pledge of collateral under Horizon’s agreement with the mortgage company. Each individual mortgage is assigned to Horizon until the loan is sold to the secondary market by the mortgage company. In addition, Horizon takes possession of each original note and forwards such note to the end investor once the mortgage company has sold the loan. At the time a loan is transferred to the secondary market, the mortgage company repurchases the loan under its option within the agreement. Due to the repurchase feature contained in the agreement, the transaction does not qualify as a sale and therefore is accounted for as a secured borrowing with a pledge of collateral pursuant to the agreement with the mortgage company. When the individual loan is sold to the end investor by the mortgage company, the proceeds from the sale of the loan are received by Horizon and used to pay off the loan balance with Horizon along with any accrued interest and any related fees. The remaining balance from the sale is forwarded to the mortgage company. These individual loans typically are sold by the mortgage company within 30 days and are seldom held more than 90 days. Interest income is accrued during this period and collected at the time each loan is sold. Fee income for each loan sold is collected when the loan is sold, and no costs are deferred due to the term between each loan funding and related payoff, which is typically less than 30 days.
Based on the agreements with each mortgage company, at any time a mortgage company can repurchase from Horizon their outstanding loan balance on an individual mortgage and regain possession of the original note. Horizon also has the option to request that the mortgage company repurchase an individual mortgage.
14
Should this occur, Horizon would return the original note and reassign the assignment of the mortgage to the mortgage company. Also, in the event that the end investor would not be able to honor the purchase commitment and the mortgage company would not be able to repurchase its loan on an individual mortgage, Horizon would be able to exercise its rights under the agreement.
The following table shows the recorded investment of individual loan categories.
Owner occupied real estate
Non owner occupied real estate
Residential spec homes
Development & spec land loans
Commercial and industrial
Total commercial
Residential construction
Total real estate
Direct installment
Direct installment purchased
Indirect installment
Total consumer
Net loans
15
Note 5 – Accounting for Certain Loans Acquired in a Transfer
The Company acquired loans in acquisitions and the transferred loans had evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.
The carrying amounts of those loans included in the balance sheet amounts of loans receivable are as follows:
Outstanding balance
Carrying amount, net of allowance of $205
Carrying amount, net of allowance of $389
Accretable yield, or income expected to be collected for the nine months ended September 30, is as follows:
Balance at January 1
Additions
Accretion
Reclassification from nonaccreatable difference
Disposals
Balance at September 30
16
During the three and nine months ended September 30, 2014, the Company increased the allowance for loan losses by a charge to the income statement of $0 and $253,000, respectively, and for the three and nine months ended September 30, 2013, $100,000 and $1.5 million, respectively. $134,000 of allowances for loan losses were reversed for the three and nine months ended September 30, 2014 and $0 of allowance for loan losses were reversed for the three and nine months ended September 30, 2013.
Note 6 – Allowance for Loan Losses
The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the prior one to five years. Management believes the five-year historical loss experience methodology is appropriate in the current economic environment, as it captures loss rates that are comparable to the current period being analyzed. The actual allowance for loan loss activity is provided below.
Balance at beginning of the period
Loans charged-off:
Residential development
Development & Spec Land Loans
Direct Installment
Direct Installment Purchased
Indirect Installment
Home Equity
Total loans charged-off
Recoveries of loans previously charged-off:
Total loan recoveries
Net loans charged-off (recovered)
Provision charged to operating expense
Total provision charged to operating expense
Balance at the end of the period
17
Certain loans are individually evaluated for impairment, and the Company’s general practice is to proactively charge down impaired loans to the fair value of the underlying collateral.
Consistent with regulatory guidance, charge-offs on all loan segments are taken when specific loans, or portions thereof, are considered uncollectible. The Company’s policy is to promptly charge these loans off in the period the uncollectible loss is reasonably determined.
For all loan portfolio segments except 1-4 family residential properties and consumer, the Company promptly charges-off loans, or portions thereof, when available information confirms that specific loans are uncollectible based on information that includes, but is not limited to, (1) the deteriorating financial condition of the borrower, (2) declining collateral values, and/or (3) legal action, including bankruptcy, that impairs the borrower’s ability to adequately meet its obligations. For impaired loans that are considered to be solely collateral dependent, a partial charge-off is recorded when a loss has been confirmed by an updated appraisal or other appropriate valuation of the collateral.
The Company charges-off 1-4 family residential and consumer loans, or portions thereof, when the Company reasonably determines the amount of the loss. The Company adheres to timeframes established by applicable regulatory guidance which provides for the charge-down or specific allocation of 1-4 family first and junior lien mortgages to the net realizable value less costs to sell when the value is known but no later than when a loan is 180 days past due. Pursuant to such guidelines, the Company also charges-off unsecured open-end loans when the loan is 90 days past due, and charges down to the net realizable value other secured loans when they are 90 days past due. Loans at these respective delinquency thresholds for which the Company can clearly document that the loan is both well-secured and in the process of collection, such that collection in full will occur regardless of delinquency status, are not charged off.
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment analysis:
Allowance For Loan Losses
Ending allowance balance attributable to loans:
Individually evaluated for impairment
Collectively evaluated for impairment
Loans acquired with deteriorated credit quality
Total ending allowance balance
Loans:
Total ending loans balance
18
Note 7 – Non-performing Loans and Impaired Loans
The following table presents the non-accrual, loans past due over 90 days still on accrual, and troubled debt restructured (“TDRs”) by class of loans:
Total Consumer
19
Included in the $10.8 million of non-accrual loans and the $3.1 million of non-performing TDRs at September 30, 2014 were $1.3 million and $362,000, respectively, of loans acquired for which accretable yield was recognized.
From time to time, the Bank obtains information that may lead management to believe that the collection of payments may be doubtful on a particular loan. In recognition of this, it is management’s policy to convert the loan from an “earning asset” to a non-accruing loan. The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified due date. Further, it is management’s policy to place a loan on a non-accrual status when the payment is delinquent in excess of 90 days or the loan has had the accrual of interest discontinued by management. The officer responsible for the loan and the Chief Credit Officer or the senior collection officer must review all loans placed on non-accrual status. Subsequent payments on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to the timely collection of interest or principal in accordance with the loan terms. The Company requires a period of satisfactory performance of not less than nine months before returning a non-accrual loan to accrual status.
A loan becomes impaired when, based on current information, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. When a loan is classified as impaired, the degree of impairment must be recognized by estimating future cash flows from the debtor. The present value of these cash flows is computed at a discount rate based on the interest rate contained in the loan agreement. However, if a particular loan has a determinable market value for its collateral, the creditor may use that value. Also, if the loan is secured and considered collateral dependent, the creditor may use the fair value of the collateral. Interest income on loans individually classified as impaired is recognized on a cash basis after all past due and current principal payments have been made.
Smaller-balance, homogeneous loans are evaluated for impairment in total. Such loans include residential first mortgage loans secured by 1 – 4 family residences, residential construction loans, automobile, home equity, second mortgage loans and mortgage warehouse loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of borrower operating results and financial condition indicate that underlying cash flows of a borrower’s business are not adequate to meet its debt service requirements, the loan is evaluated for impairment. Often this is associated with a delay or shortfall in payments of 30 days or more. Loans are generally moved to non-accrual status when they are 90 days or more past due. These loans are often considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms, including TDRs, are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans.
The Company’s TDRs are considered impaired loans and included in the allowance methodology using the guidance for impaired loans. At September 30, 2014, the type of concessions the Company has made on restructured loans has been temporary rate reductions and/or reductions in monthly payments and there have been no restructured loans with modified recorded balances. Any modification to a loan that is a concession and is not in the normal course of lending is considered a restructured loan. A restructured loan is returned to accruing status after six consecutive payments but is still reported as TDR unless the loan bears interest at a market rate. As of September 30, 2014, the Company had $8.9 million in TDRs and $5.8 million were performing according to the restructured terms and no TDRs were returned to accrual status during the first nine months of 2014. There was $1.5 million of specific reserves allocated to TDRs at September 30, 2014 based on the discounted cash flows.
20
Loans transferred and classified as troubled debt restructuring during the three and nine months ended September 30, 2014 and 2013, segregated by class, are shown in the table below.
Troubled debt restructured loans which had payment defaults during the three and nine months ended September 30, 2014 and 2013, segregated by class, are shown in the table below. Default occurs when a loan is 90 days or more past due or has been transferred to non-accrual.
21
The following table presents commercial loans individually evaluated for impairment by class of loan:
With no recorded allowance
With an allowance recorded
22
The following table presents the payment status by class of loan:
Percentage of total loans
The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified due date.
Horizon Bank’s processes for determining credit quality differ slightly depending on whether a new loan or a renewed loan is being underwritten, or whether an existing loan is being re-evaluated for credit quality. The latter usually occurs upon receipt of current financial information or other pertinent data that would trigger a change in the loan grade.
23
For residential real estate and consumer loans, Horizon uses a grading system based on delinquency. Loans that are 90 days or more past due, on non-accrual, or are classified as a TDR are graded “Substandard.” After being 90 days delinquent a loan is charged off unless it is well secured and in the process of collection. If the latter case exists, the loan is placed on non-accrual. Occasionally a mortgage loan may be graded as “Special Mention.” When this situation arises, it is because the characteristics of the loan and the borrower fit the definition of a Risk Grade 5 described below, which is normally used for grading commercial loans. Loans not graded Substandard are considered Pass.
Horizon Bank employs a nine-grade rating system to determine the credit quality of commercial loans. The first five grades represent acceptable quality, and the last four grades mirror the criticized and classified grades used by the bank regulatory agencies (special mention, substandard, doubtful, and loss). The loan grade definitions are detailed below.
Risk Grade 1: Excellent (Pass)
Loans secured by liquid collateral, such as certificates of deposit, reputable bank letters of credit, or other cash equivalents; loans that are guaranteed or otherwise backed by the full faith and credit of the United States government or an agency thereof, such as the Small Business Administration; or loans to any publicly held company with a current long-term debt rating of A or better.
Risk Grade 2: Good (Pass)
Loans to businesses that have strong financial statements containing an unqualified opinion from a CPA firm and at least three consecutive years of profits; loans supported by unaudited financial statements containing strong balance sheets, five consecutive years of profits, a five-year satisfactory relationship with the Bank, and key balance sheet and income statement trends that are either stable or positive; loans secured by publicly traded marketable securities where there is no impediment to liquidation; loans to individuals backed by liquid personal assets and unblemished credit history; or loans to publicly held companies with current long-term debt ratings of Baa or better.
Risk Grade 3: Satisfactory (Pass)
Loans supported by financial statements (audited or unaudited) that indicate average or slightly below average risk and having some deficiency or vulnerability to changing economic conditions; loans with some weakness but offsetting features of other support are readily available; loans that are meeting the terms of repayment, but which may be susceptible to deterioration if adverse factors are encountered.
Loans may be graded Satisfactory when there is no recent information on which to base a current risk evaluation and the following conditions apply:
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Risk Grade 4 Satisfactory/Monitored:
Loans in this category are considered to be of acceptable credit quality, but contain greater credit risk than Satisfactory loans. Borrower displays acceptable liquidity, leverage, and earnings performance within the Bank’s minimum underwriting guidelines. The level of risk is acceptable but conditioned on the proper level of loan officer supervision. Loans that normally fall into this grade include acquisition, construction and development loans and income producing properties that have not reached stabilization.
Risk Grade 4W Management Watch:
Loans in this category are considered to be of acceptable quality, but with above normal risk. Borrower displays potential indicators of weakness in the primary source of repayment resulting in a higher reliance on secondary sources of repayment. Balance sheet may exhibit weak liquidity and/or high leverage. There is inconsistent earnings performance without the ability to sustain adverse economic conditions. Borrower may be operating in a declining industry or the property type, as for a commercial real estate loan, may be high risk or in decline. These loans require an increased level of loan officer supervision and monitoring to assure that any deterioration is addressed in a timely fashion.
Risk Grade 5: Special Mention
Loans which possess some credit deficiency or potential weakness which deserves close attention. Such loans pose an unwarranted financial risk that, if not corrected, could weaken the loan by adversely impacting the future repayment ability of the borrower. The key distinctions of a Special Mention classification are that (1) it is indicative of an unwarranted level of risk and (2) weaknesses are considered “potential,” not “defined,” impairments to the primary source of repayment. These loans may be to borrowers with adverse trends in financial performance, collateral value and/or marketability, or balance sheet strength.
Risk Grade 6: Substandard
One or more of the following characteristics may be exhibited in loans classified Substandard:
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Risk Grade 7: Doubtful
One or more of the following characteristics may be present in loans classified Doubtful:
Risk Grade 8: Loss
Loans are considered uncollectible and of such little value that continuing to carry them as assets is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.
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The following table presents loans by credit grades.
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Note 8 – Derivative Financial Instruments
Cash Flow Hedges
As a strategy to maintain acceptable levels of exposure to the risk of changes in future cash flow due to interest rate fluctuations, the Company entered into interest rate swap agreements for a portion of its floating rate debt. The agreements provide for the Company to receive interest from the counterparty at three month LIBOR and to pay interest to the counterparty at a weighted average fixed rate of 6.14% on a notional amount of $30.5 million at September 30, 2014 and December 31, 2013. Under the agreements, the Company pays or receives the net interest amount monthly, with the monthly settlements included in interest expense.
Management has designated the interest rate swap agreement as a cash flow hedging instrument. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings. At September 30, 2014 the Company’s cash flow hedge was effective and is not expected to have a significant impact on the Company’s net income over the next 12 months.
Fair Value Hedges
Fair value hedges are intended to reduce the interest rate risk associated with the underlying hedged item. The Company enters into fixed rate loan agreements as part of its lending policy. To mitigate the risk of changes in fair value based on fluctuations in interest rates, the Company has entered into interest rate swap agreements on individual loans, converting the fixed rate loans to a variable rate. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in current earnings. At September 30, 2014, the Company’s fair value hedges were effective and are not expected to have a significant impact on the Company’s net income over the next 12 months.
The change in fair value of both the hedge instruments and the underlying loan agreements are recorded as gains or losses in interest income. The fair value hedges are considered to be highly effective and any hedge ineffectiveness was deemed not material. The notional amounts of the loan agreements being hedged were $102.4 million at September 30, 2014 and $95.3 million at December 31, 2013.
Other Derivative Instruments
The Company enters into non-hedging derivatives in the form of mortgage loan forward sale commitments with investors and commitments to originate mortgage loans as part of its mortgage banking business. At September 30, 2014, the Company’s fair value of these derivatives were recorded and over the next 12 months are not expected to have a significant impact on the Company’s net income.
The change in fair value of both the forward sale commitments and commitments to originate mortgage loans were recorded and the net gains or losses included in the Company’s gain on sale of loans.
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The following tables summarize the fair value of derivative financial instruments utilized by Horizon:
Interest rate contracts
Total derivatives designated as hedging instruments
Mortgage loan contracts
Total derivatives not designated as hedging instruments
Total derivatives
The effect of the derivative instruments on the condensed consolidated statement of income for the three and nine month periods ending is as follows:
Derivative in cash flow hedging relationship
FASB Accounting Standards Codification (“ASC”) Topic 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Topic 820-10-55 establishes a fair value hierarchy that emphasizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.
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Derivative in fair value hedgingrelationship
Location of gain (loss)recognized on derivative
Derivative not designated as hedgingrelationship
Mortgage contracts
Note 9 – Disclosures about Fair Value of Assets and Liabilities
The Fair Value Measurements topic of the FASB ASC defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. There are three levels of inputs that may be used to measure fair value:
Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying condensed consolidated financial statements, as well as the general classification of such instruments pursuant to the valuation hierarchy. There have been no significant changes in the valuation techniques during the period ended September 30, 2014. For assets classified within Level 3 of the fair value hierarchy, the process used to develop the reported fair value is described below.
Available for sale securities
When quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. Treasury and federal agency securities, state and municipal securities, federal agency mortgage obligations and mortgage-backed pools, private-label mortgage-backed pools and corporate notes. Level 2 securities are valued by a third party pricing service commonly used in the banking industry utilizing observable inputs. Observable inputs include dealer quotes, market spreads, cash flow analysis, the U.S. Treasury yield curve, trade execution data, market consensus prepayment spreads and available credit information and the bond’s terms and conditions. The pricing provider utilizes evaluated pricing models that vary based on asset class. These models incorporate available market information including quoted prices of securities with similar characteristics and, because many fixed-income securities do not trade on a daily basis, apply available information through processes such as benchmark curves, benchmarking of like securities, sector grouping, and matrix pricing. In addition, model processes, such as an option adjusted spread model, is used to develop prepayment and interest rate scenarios for securities with prepayment features.
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Hedged loans
Certain fixed rate loans have been converted to variable rate loans by entering into interest rate swap agreements. The fair value of those fixed rate loans is based on discounting the estimated cash flows using interest rates determined by the respective interest rate swap agreement. Loans are classified within Level 2 of the valuation hierarchy based on the unobservable inputs used.
Interest rate swap agreements
The fair value of the Company’s interest rate swap agreements is estimated by a third party using inputs that are primarily unobservable including a yield curve, adjusted for liquidity and credit risk, contracted terms and discounted cash flow analysis, and therefore, are classified within Level 2 of the valuation hierarchy.
The following table presents the fair value measurements of assets and liabilities recognized in the accompanying condensed consolidated financial statements measured at fair value on a recurring basis and the level within the FASB ASC fair value hierarchy in which the fair value measurements fall at the following:
September 30, 2014
Available-for-sale securities
Total available-for-sale securities
Forward sale commitments
Commitments to originate loans
December 31, 2013
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Realized gains and losses included in net income for the periods are reported in the condensed consolidated statements of income as follows:
Fair value interest rate swap agreements
Derivative loan commitments
Certain other assets are measured at fair value on a nonrecurring basis in the ordinary course of business and are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment):
Impaired loans
Mortgage servicing rights
Impaired (collateral dependent): Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans.
If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.
Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.
Mortgage Servicing Rights (MSRs): MSRs do not trade in an active market with readily observable prices. Accordingly, the fair value of these assets is classified as Level 3. The Company determines the fair value of MSRs using an income approach model based upon the Company’s month-end interest rate curve and prepayment assumptions. The model utilizes assumptions to estimate future net servicing income cash flows, including estimates of time decay, payoffs and changes in valuation inputs and assumptions. The Company reviews the valuation assumptions against this market data for reasonableness and adjusts the assumptions if deemed appropriate. The carrying amount of the MSR’s fair value increased by $28,000 during the first nine months of 2014 and increased by $208,000 during the first nine months of 2013.
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The following table presents qualitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements, other than goodwill.
Valuation
Technique
Unobservable Inputs
Note 10 – Fair Value of Financial Instruments
The estimated fair value amounts of the Company’s financial instruments were determined using available market information, current pricing information applicable to Horizon and various valuation methodologies. Where market quotations were not available, considerable management judgment was involved in the determination of estimated fair values. Therefore, the estimated fair value of financial instruments shown below may not be representative of the amounts at which they could be exchanged in a current or future transaction. Due to the inherent uncertainties of expected cash flows of financial instruments, the use of alternate valuation assumptions and methods could have a significant effect on the estimated fair value amounts.
The estimated fair values of financial instruments, as shown below, are not intended to reflect the estimated liquidation or market value of Horizon taken as a whole. The disclosed fair value estimates are limited to Horizon’s significant financial instruments at September 30, 2014 and December 31, 2013. These include financial instruments recognized as assets and liabilities on the condensed consolidated balance sheet as well as certain off-balance sheet financial instruments. The estimated fair values shown below do not include any valuation of assets and liabilities, which are not financial instruments as defined by the FASB ASC fair value hierarchy.
The following methods and assumptions were used to estimate the fair value of each class of financial instrument:
Cash and Due from Banks — The carrying amounts approximate fair value.
Held-to-Maturity Securities — For debt securities held to maturity, fair values are based on quoted market prices or dealer quotes. For those securities where a quoted market price is not available, carrying amount is a reasonable estimate of fair value based upon comparison with similar securities.
Loans Held for Sale — The carrying amounts approximate fair value.
Net Loans — The fair value of portfolio loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The carrying amounts of loans held for sale approximate fair value.
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FHLB and FRB Stock — Fair value of FHLB and FRB stock is based on the price at which it may be resold to the FHLB and FRB.
Interest Receivable/Payable — The carrying amounts approximate fair value.
Deposits — The fair value of demand deposits, savings accounts, interest-bearing checking accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated by discounting the future cash flows using rates currently offered for deposits of similar remaining maturity.
Borrowings — Rates currently available to Horizon for debt with similar terms and remaining maturities are used to estimate fair values of existing borrowings.
Subordinated Debentures — Rates currently available for debentures with similar terms and remaining maturities are used to estimate fair values of existing debentures.
Commitments to Extend Credit and Standby Letters of Credit — The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. Due to the short-term nature of these agreements, carrying amounts approximate fair value.
The following table presents estimated fair values of the Company’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall (unaudited).
Investment securities, held to maturity
Loans excluding loan level hedges, net
Stock in FHLB and FRB
Non-interest bearing deposits
Interest-bearing deposits
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Note 11 – Accumulated Other Comprehensive Income (Loss)
Unrealized gain on securities available for sale
Unamortized gain on securities held to maturity, previously transferred from AFS
Unrealized loss on derivative instruments
Tax effect
Total accumulated other comprehensive income (loss)
Note 12 – Future Accounting Matters
Accounting Standards Update (“ASU” or “Update”) 2014-01, Investments - Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (January 2014) - This Update permits entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. The ASU modifies the conditions that an entity must meet to be eligible to use a method other than the equity or cost methods to account for qualified affordable housing project investments. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. The amendments in this Update should be applied retrospectively to all periods presented. Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.
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ASU 2014-04, Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (January 2014) - The objective of this Update is to reduce diversity by clarifying when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. The amendments in this Update may be adopted using either a modified retrospective transition method or a prospective transition method. Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.
ASU 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity (April 2014). - This Update seeks to better define the groups of assets which qualify for discontinued operations, in order to ease the burden and cost for preparers and stakeholders. This issue changed “the criteria for reporting discontinued operations” and related reporting requirements, including the provision for disclosures about the “disposal of an individually significant component of an entity that does not qualify for discontinued operations presentation.” The amendments in this Update are effective for fiscal years beginning after December 15, 2014. Early adoption is permitted only for disposals or classifications as held for sale. The Company will adopt the methodologies prescribed by this ASU by the date required. Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.
ASU 2014-11, Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures (June 2014). - This Update addresses the concerns of stakeholders’ by changing the accounting practices surrounding repurchase agreements. The new guidance changes the “accounting for repurchase-to-maturity transactions and linked repurchase financings to secured borrowing accounting, which is consistent with the accounting for other repurchase agreements.” The amendments in this Update are effective for annual reporting periods beginning after December 15, 2014. Early adoption is prohibited. The Company will adopt the methodologies prescribed by this ASU by the date required. Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.
ASU 2014-12, Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (June 2014). - This Update defines the accounting treatment for share-based payments and “resolves the diverse accounting treatment of those awards in practice.” The new requirement mandates that “a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition.” Compensation cost will now be recognized in the period in which it becomes likely that the performance target will be met. The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company will adopt the methodologies prescribed by this ASU by the date required. Adoption of the ASU is not expected to have a significant effect on the Company’s consolidated financial statements.
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Management’s Discussion and Analysis of Financial Condition
And Results of Operations
For the Three and Nine Months Ended September 30, 2014
Forward–Looking Statements
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, with respect to Horizon Bancorp (“Horizon” or the “Company”) and Horizon Bank, N.A. (the “Bank”). Horizon intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and is including this statement for the purposes of these safe harbor provisions. Statements in this report should be considered in conjunction with the other information available about Horizon, including the information in the other filings we make with the Securities and Exchange Commission. The forward-looking statements are based on management’s expectations and are subject to a number of risks and uncertainties. We have tried, wherever possible, to identify such statements by using words such as “anticipate,” “expect,” “estimate,” “project,” “intend,” “plan,” “believe,” “could,” “will” and similar expressions in connection with any discussion of future operating or financial performance. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements.
Actual results may differ materially, adversely or positively, from the expectations of the Company that are expressed or implied by any forward-looking statement. Risks, uncertainties, and factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statement include but are not limited to:
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The foregoing list of important factors is not exclusive, and you are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document or, in the case of documents incorporated by reference, the dates of those documents. We do not undertake to update any forward-looking statements, whether written or oral, that may be made from time to time by or on behalf of us. For a detailed discussion of the risks and uncertainties that may cause our actual results or performance to differ materially from the results or performance expressed or implied by forward-looking statements, see “Risk Factors” in Item 1A of Part I of our 2013 Annual Report on Form 10-K and in the subsequent reports we file with the SEC.
Overview
Horizon is a registered bank holding company incorporated in Indiana and headquartered in Michigan City, Indiana. Horizon provides a broad range of banking services in Northwestern and Central Indiana and Southwestern and South Central Michigan through its bank subsidiary. Horizon operates as a single segment, which is commercial banking. Horizon’s common stock is traded on the NASDAQ Global Market under the symbol HBNC. The Bank was chartered as a national banking association in 1873 and has operated continuously since that time. The Bank is a full-service commercial bank offering commercial and retail banking services, corporate and individual trust and agency services, and other services incident to banking.
On November 12, 2013, Horizon entered into an Agreement and Plan of Merger (the “Merger Agreement”) providing for Horizon’s acquisition of SCB Bancorp, Inc., a Michigan corporation (“Summit”). Pursuant to the Merger Agreement, Summit would merge with and into Horizon, with Horizon surviving the merger (the “Merger”), and Summit Community Bank, a Michigan-chartered commercial bank and wholly owned subsidiary of SCB Bancorp, Inc., would merge with and into a wholly owned subsidiary of Horizon, Horizon Bank, N.A. (“Horizon Bank”), with Horizon Bank as the surviving bank.
On April 3, 2014, Horizon completed the acquisition of Summit and Horizon Bank’s acquisition of Summit Community Bank, through mergers effective April 3, 2014. Under the terms of the acquisition, the exchange ratio was 0.4904 shares of Horizon common stock and $5.15 in cash for each outstanding share of Summit common stock. Summit shares outstanding at the closing were 1,164,442, and the shares of Horizon’s common stock issued to Summit shareholders totaled 570,820. Horizon’s stock price was $22.23 per share at the close of business on April 3, 2014. Based upon these numbers, the total value of the consideration for the acquisition was $18.9 million (not including the retirement of Summit debt).
Following are some highlights of Horizon’s financial performance through the third quarter of 2014:
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Critical Accounting Policies
The notes to the consolidated financial statements included in Item 8 of the Company’s Annual Report on Form 10-K for 2013 contain a summary of the Company’s significant accounting policies. Certain of these policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Management has identified as critical accounting policies the allowance for loan losses, intangible assets, mortgage servicing rights, hedge accounting and valuation measurements.
Allowance for Loan Losses
An allowance for loan losses is maintained to absorb probable incurred loan losses inherent in the loan portfolio. The determination of the allowance for loan losses is a critical accounting policy that involves management’s ongoing quarterly assessments of the probable incurred losses inherent in the loan portfolio. The identification of loans that have probable incurred losses is subjective; therefore, a general reserve is maintained to cover all probable losses within the entire loan portfolio. Horizon utilizes a loan grading system that helps identify, monitor and address asset quality problems in an adequate and timely manner. Each quarter, various factors affecting the quality of the loan portfolio are reviewed. Large credits are reviewed on an individual basis for loss potential. Other loans are reviewed as a group based upon previous trends of loss experience. Horizon also reviews the current and anticipated economic conditions of its lending market as well as transaction risk to determine the effect they may have on the loss experience of the loan portfolio.
Goodwill and Intangible Assets
Management believes that the accounting for goodwill and other intangible assets also involves a higher degree of judgment than most other significant accounting policies. FASB ASC 350-10 establishes standards for the amortization of acquired intangible assets and impairment assessment of goodwill. At September 30, 2014, Horizon had core deposit intangibles of $4.2 million subject to amortization and $28.0 million of goodwill, which is not subject to amortization. Goodwill arising from business combinations represents the value attributable to unidentifiable intangible assets in the business acquired. Horizon’s goodwill relates to the value inherent in the banking industry and that value is dependent upon the ability of Horizon to provide quality, cost effective banking services in a competitive marketplace. The goodwill value is supported by revenue that is in part driven by the volume of business transacted. A decrease in earnings resulting from a decline in the customer base or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely affect earnings in future periods. FASB ASC 350-10 requires an annual evaluation of goodwill for impairment. The evaluation of goodwill for impairment requires the use of estimates and assumptions. Market price at the close of business on September 30, 2014 was $23.04 per share compared to a book value of $19.25 per common share. Horizon reported record earnings for the fourteenth consecutive year in 2013.
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Horizon has concluded that, based on its own internal evaluation, the recorded value of goodwill is not impaired.
Mortgage Servicing Rights
Servicing assets are recognized as separate assets when rights are acquired through purchase or through the sale of financial assets on a servicing-retained basis. Capitalized servicing rights are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated regularly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying servicing rights by predominant characteristics, such as interest rates, original loan terms and whether the loans are fixed or adjustable rate mortgages. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. When the book value of an individual stratum exceeds its fair value, an impairment reserve is recognized so that each individual stratum is carried at the lower of its amortized book value or fair value. In periods of falling market interest rates, accelerated loan prepayment can adversely affect the fair value of these mortgage-servicing rights relative to their book value. In the event that the fair value of these assets was to increase in the future, Horizon can recognize the increased fair value to the extent of the impairment allowance but cannot recognize an asset in excess of its amortized book value. Future changes in management’s assessment of the impairment of these servicing assets, as a result of changes in observable market data relating to market interest rates, loan prepayment speeds, and other factors, could impact Horizon’s financial condition and results of operations either positively or negatively.
Generally, when market interest rates decline and other factors favorable to prepayments occur, there is a corresponding increase in prepayments as customers refinance existing mortgages under more favorable interest rate terms. When a mortgage loan is prepaid, the anticipated cash flows associated with servicing that loan are terminated, resulting in a reduction of the fair value of the capitalized mortgage servicing rights. To the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments and could result in significant earnings volatility. To estimate prepayment speeds, Horizon utilizes a third-party prepayment model, which is based upon statistically derived data linked to certain key principal indicators involving historical borrower prepayment activity associated with mortgage loans in the secondary market, current market interest rates and other factors, including Horizon’s own historical prepayment experience. For purposes of model valuation, estimates are made for each product type within the mortgage servicing rights portfolio on a monthly basis. In addition, on a quarterly basis Horizon engages a third party to independently test the value of its servicing asset.
Derivative Instruments
As part of the Company’s asset/liability management program, Horizon utilizes, from time-to-time, interest rate floors, caps or swaps to reduce the Company’s sensitivity to interest rate fluctuations. These are derivative instruments, which are recorded as assets or liabilities in the consolidated balance sheets at fair value. Changes in the fair values of derivatives are reported in the consolidated income statements or other comprehensive income (“OCI”) depending on the use of the derivative and whether the instrument qualifies for hedge accounting. The key criterion for the hedge accounting is that the hedged relationship must be highly effective in achieving offsetting changes in those cash flows that are attributable to the hedged risk, both at inception of the hedge and on an ongoing basis.
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Horizon’s accounting policies related to derivatives reflect the guidance in FASB ASC 815-10. Derivatives that qualify for the hedge accounting treatment are designated as either: a hedge of the fair value of the recognized asset or liability or of an unrecognized firm commitment (a fair value hedge) or a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (a cash flow hedge). For fair value hedges, the cumulative change in fair value of both the hedge instruments and the underlying loans is recorded in non-interest income. For cash flow hedges, changes in the fair values of the derivative instruments are reported in OCI to the extent the hedge is effective. The gains and losses on derivative instruments that are reported in OCI are reflected in the consolidated income statement in the periods in which the results of operations are impacted by the variability of the cash flows of the hedged item. Generally, net interest income is increased or decreased by amounts receivable or payable with respect to the derivatives, which qualify for hedge accounting. At inception of the hedge, Horizon establishes the method it uses for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The ineffective portion of the hedge, if any, is recognized currently in the consolidated statements of income. Horizon excludes the time value expiration of the hedge when measuring ineffectiveness.
Valuation Measurements
Valuation methodologies often involve a significant degree of judgment, particularly when there are no observable active markets for the items being valued. Investment securities, residential mortgage loans held for sale and derivatives are carried at fair value, as defined in FASB ASC 820, which requires key judgments affecting how fair value for such assets and liabilities is determined. In addition, the outcomes of valuations have a direct bearing on the carrying amounts of goodwill, mortgage servicing rights, and pension and other post-retirement benefit obligations. To determine the values of these assets and liabilities, as well as the extent, to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, prepayment speeds and other factors. The use of different discount rates or other valuation assumptions could produce significantly different results, which could affect Horizon’s results of operations.
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Financial Condition
On September 30, 2014, Horizon’s total assets were $2.0 billion, an increase of approximately $278.8 million compared to December 31, 2013. The increase was primarily due to the growth in net loans of $274.0 million, consisting of $124.0 million in loans acquired in the Summit acquisition and $150.0 million of loans from organic growth.
Investment securities were comprised of the following as of (dollars in thousands):
Total investment securities decreased by approximately $22.6 million at September 30, 2014 compared to December 31, 2013 as a result of an analysis that determined market conditions provided the opportunity to sell securities and add gains to capital without negatively impacting long-term earnings. The sale of securities was also used to fund loan growth. In the second quarter of 2014, Horizon reclassified securities with a book value of $165.1 million and a net unrealized gain of $2.0 million from available for sale to held to maturity. At the time of reclassification, the fair value of the securities of $167.1 million was reclassified as held to maturity. This reclassification was made due to Horizon’s intent and ability to hold these securities to maturity. Investments classified as held to maturity are subsequently measured at amortized cost on the balance sheet.
Total loans increased $275.1 million since December 31, 2013 to $1.3 billion as of September 30, 2014. This increase was the result of an increase in commercial loans of $172.2 million, mortgage warehouse loans of $7.0 million, residential mortgage loans of $65.8 million and consumer loans of $29.3 million. On April 3, 2014, as part of the Summit acquisition, Horizon acquired $124.0 million in loans. These loans consisted of $70.4 million in commercial, $43.4 million of residential mortgage and $10.2 million of consumer. The growth in total loans during the nine months ended September 30, 2014 is the direct result of increased calling efforts to increase Horizon’s market share within the Company’s footprint, organic market expansion and the Summit acquisition.
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The following table presents the amount and growth rate of loans by product type for the nine months ended September 30, 2014.
Loan Growth by Type
Nine Months Ended September 30, 2014
(Dollars in Thousands)
Commercial loans
Residential mortgage loans
Consumer loans
Held for sale loans
Subtotal
Mortgage warehouse loans
Total deposits increased $158.1 million since December 31, 2013. This increase was the result of organic growth of $37.1 million and deposits acquired in the Summit acquisition totaling $121.0 million as of September 30, 2014. Non-interest bearing deposit accounts increased by $47.4 million, interest-bearing transaction accounts increased by $101.3 million and time deposits increased by $9.4 million during the nine months ended September 30, 2014.
The Company’s borrowings increased $93.8 million from December 31, 2013 as total loan growth of $275.1 million outpaced deposit growth of $158.1 million during the nine months ended September 30, 2014, thereby increasing the Company’s reliance on borrowings to fund loan growth during the period. At September 30, 2014, the Company had $110.0 million in short-term funds borrowed compared to $41.0 million at December 31, 2013. The Company’s current balance sheet strategy is to utilize a reasonable level of short-term borrowings during extended low rate environments in addition to what is needed for the fluctuations in mortgage warehouse lending.
Stockholders’ equity totaled $189.8 million at September 30, 2014 compared to $164.5 million at December 31, 2013. The increase in stockholders’ equity during the period was the result of the generation of net income, an increase in accumulated other comprehensive income and common stock issued in the Summit acquisition, net of dividends declared. At September 30, 2014, the ratio of average stockholders’ equity to average assets was 9.33% compared to 9.46% for December 31, 2013. Book value per common share at September 30, 2014 increased to $19.25 compared to $17.64 at December 31, 2013.
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Results of Operations
Consolidated net income for the three-month period ended September 30, 2014 was $5.0 million, an increase of 3.6% from the $4.8 million for the same period in 2013. Earnings per common share for the three months ended September 30, 2014 were $0.53 basic and $0.51 diluted, compared to $0.55 basic and $0.52 diluted for the same three-month period in 2013. Diluted earnings per share decreased by $.01 compared to the same three-month period in 2013 due to an increase in the amount of shares outstanding as a result of the Summit acquisition.
Consolidated net income for the nine-month period ended September 30, 2014 was $13.2 million, a decrease of 16.5% from $15.8 million for the same period in 2013. Earnings per common share for the nine months ended September 30, 2014 were $1.45 basic and $1.39 diluted, compared to $1.79 basic and $1.72 diluted for the same nine-month period in 2013. Diluted earnings per share decreased by $.33 compared to the same nine-month period in 2013 due primarily to lower interest income on loans as a result of a decrease in accretion income from acquisition-related purchase accounting adjustments, lower non-interest income from a decline in gain on sale of mortgage loans and an increase in non-interest expenses primarily due to an increase in salaries and employee benefits from company growth and transaction expenses related to the Summit acquisition. Additionally, the decrease in diluted earnings per share reflects the shares issued to Summit shareholders as part of the transaction.
The largest component of net income is net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on deposits and borrowings. Changes in the net interest income are the result of changes in volume and the net interest spread, which affects the net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.
Net interest income during the three months ended September 30, 2014 was $16.4 million, an increase of $1.7 million from the $14.7 million earned during the same period in 2013. Yields on the Company’s interest-earning assets decreased by 29 basis points to 4.32% for the three months ending September 30, 2014 from 4.61% for the three months ended September 30, 2013. Interest income increased $1.8 million from $18.0 million for the three months ended September 30, 2013 to $19.9 million for the same period in 2014. This increase was due to an increase in interest-earning assets offset by lower yields on loans and investment securities and a decrease in interest income from acquisition-related purchase accounting adjustments from $1.0 million for the third quarter of 2013 to $438,000 for the same period of 2014.
Rates paid on interest-bearing liabilities decreased by 11 basis points for the three months ended September 30, 2014 compared to the same period in 2013 due to the continued low interest rate environment. Interest expense increased $79,000 from $3.4 million for the three months ended September 30, 2013 to $3.5 million for the same period in 2014. This increase was due to higher balances of both interest-bearing deposits and borrowings. The net interest margin decreased 19 basis points from 3.78% for the three months ended September 30, 2013 to 3.59% for the same period in 2014. The decrease in the margin for the three months ended September 30, 2014 compared to the same period in 2013 was due to the decrease of approximately $606,000 of interest income from acquisition-related purchase accounting adjustments as well as a reduction in the yield on interest-earning assets. Excluding the interest income recognized from the acquisition-related purchase accounting adjustments, the margin would have been 3.50% for the three-month period ending September 30, 2014 compared to 3.52% for the same period in 2013.
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The following are the average balance sheets for the three months ending (dollars in thousands):
Interest-earning assets
Federal funds sold
Interest-earning deposits
Investment securities - taxable
Investment securities - non-taxable (1)
Loans receivable (2)(3)
Total interest-earning assets (1)
Noninterest-earning assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing liabilities
Total interest-bearing liabilities
Noninterest-bearing liabilities
Demand deposits
Accrued interest payable and other liabilities
Shareholders’ equity
Net interest income/spread
Net interest income as a percent of average interest earning assets (1)
Net interest income during the nine months ended September 30, 2014 was $46.5 million, a decrease of $794,000 from the $47.3 million earned during the same period in 2013. Yields on the Company’s interest-earning assets decreased by 53 basis points to 4.37% for the nine months ended September 30, 2014 from 4.90% for the same period in 2013. Interest income decreased $1.0 million from $57.5 million for the nine months ended September 30, 2013 to $56.4 million for the same period in 2014. This decrease was primarily due to lower yields on loans and a decrease in interest income from acquisition-related purchase accounting adjustments from $5.4 million for the first nine months of 2013 to $2.0 million for the same period of 2014.
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Rates paid on interest-bearing liabilities decreased by 10 basis points for the nine months ended September 30, 2014 compared to the same period in 2013 due to the continued low interest rate environment. Interest expense decreased $213,000 from $10.2 million for the nine months ended September 30, 2013 to $10.0 million for the same period of 2014. This decrease was due to lower rates being paid on the Company’s interest-bearing liabilities partially offset by higher volume of interest-bearing liabilities. The net interest margin decreased 44 basis points from 4.06% for the nine months ended September 30, 2013 to 3.62% for the same period in 2014. The decrease in the margin for the nine months ended September 30, 2014 compared to the same period in 2013 was due to the decrease of approximately $3.3 million of interest income from acquisition-related purchase accounting adjustments as well as a reduction in the yield on interest-earning assets. Excluding the interest income recognized from the acquisition-related purchase accounting adjustments, the margin would have been 3.47% for the nine months ending September 30, 2014 compared to 3.61% for the same period in 2013.
The following are the average balance sheets for the nine months ending (dollars in thousands):
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Provision for Loan Losses
Horizon assesses the adequacy of its Allowance for Loan and Lease Losses (“ALLL”) by regularly reviewing the performance of its loan portfolios. During the three-month period ended September 30, 2014, a provision of $1.7 million was required to adequately fund the ALLL compared to a provision of $104,000 for the same period of 2013. Commercial loan net charge-offs during the three months ended September 30, 2014 were $1.0 million, residential mortgage loan net charge-offs were $19,000, and consumer loan net charge-offs were $217,000. The higher provision for loan losses in the third quarter of 2014 compared to the same period of 2013 was partially due to a $1.0 million charge-off associated with one commercial credit during the quarter. The ALLL balance at September 30, 2014 was $16.2 million or 1.20% of total loans. This compares to an ALLL balance of $16.0 million at December 31, 2013 or 1.49% of total loans. The decrease in the ratio at September 30, 2014 compared to December 31, 2013 was due to an increase in total loans of $275.1 million.
Horizon’s loan loss reserve ratio, excluding loans with credit-related purchase accounting adjustments, stood at 1.32% as of September 30, 2014. The table below details Horizon’s loan loss reserve ratio composition as of September 30, 2014.
Allowance for Loan and Lease Loss Detail
As of September 30, 2014
(Dollars in Thousands, Unaudited)
Pre-discount loan balance
Allowance for loan losses (ALLL)
Loan discount
Total ALLL+loan discount
ALLL/ pre-discount loan balance
Loan discount/ pre-discount loan balance
Total ALLL+loan discount/ pre-discount loan balance
For the nine-month period ended September 30, 2014, the provision for loan losses totaled $2.1 million compared to $2.9 million in the same period of 2013. The lower provision for loan losses in the first nine months of 2014 compared to the same period of 2013 was due to the improvement of non-performing and substandard loans.
No assurance can be given that Horizon will not, in any particular period, sustain loan losses that are significant in relation to the amount reserved, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, including economic conditions and management’s ongoing quarterly assessments of the portfolio, will not require increases in the allowance for loan losses. Horizon considers the allowance for loan losses to be appropriate to cover probable incurred losses in the loan portfolio as of September 30, 2014.
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Non-performing loans totaled $19.8 million on September 30, 2014, up from $18.3 million on December 31, 2013. Compared to December 31, 2013, non-performing commercial loans and real estate loans increased by $1.9 million and $167,000, respectively, partially offset by a decrease of $506,000 in non-performing consumer loans.
At September 30, 2014, loans acquired in the Summit acquisition represented $1.2 million in non-performing, $2.5 million in substandard and $4,000 in delinquent loans. At September 30, 2014, loans acquired in the Heartland acquisition represented $3.1 million in non-performing, $4.9 million in substandard and $225,000 in delinquent loans, which compares to $4.5 million in non-performing, $10.3 million in substandard and $323,000 in delinquent loans at December 31, 2013.
Other Real Estate Owned (OREO) totaled $1.3 million on September 30, 2014, down from $2.1 million on December 31, 2013 and $1.4 million on September 30, 2013.
The following is a summary of changes in non-interest income (table dollar amounts in thousands):
Gain on sale of securities
Mortgage servicing net of impairment
Increase in cash surrender value of bank owned life insurance
Total non-interest income was $1.5 million higher in the third quarter of 2014 compared to the same period of 2013. Interchange fees increased by $100,000, primarily due to an increase in volume. Fiduciary activity fees increased $178,000, primarily due to customer and market value growth. Gain on sale of securities increased $982,000 due to a gain on sale of securities of $988,000 during the third quarter of 2014. This gain was the result of an analysis that determined market conditions provided the opportunity to add gains to capital without negatively impacting long-term earnings. The sale of securities was also used to fund loan growth. Residential mortgage loan activity during the third quarter of 2014 generated $2.2 million of income from the gain on sale of mortgage loans, up $486,000 from the same period in 2013. The increase in the gain on sale of mortgages loans was due to an increase in the percentage earned on the sale of these loans, partially offset by a decrease in total loans sold of $21.2 million from $91.8 million in the third quarter of 2013 to $70.6 million in the third quarter of 2014. Mortgage servicing net of impairment decreased by $232,000 compared to the previous year primarily due to an increase in amortization expense as of a result of loans being refinanced.
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Total non-interest income was $680,000 lower in the first nine months of 2014 compared to the same period of 2013. Wire transfer fees were $154,000 lower during the first nine months of 2014 compared to the same period in 2013 primarily due to a decrease in volume. Interchange fees were $387,000 higher during the first nine months of 2014 compared to the same period in 2013 primarily due to an increase in volume. Fiduciary activity fees increased $238,000, primarily due to customer and market value growth. Gain on sale of securities increased $614,000 due to a gain on sale of securities of $988,000 during the nine months ended 2014. This gain was the result of an analysis that determined market conditions provided the opportunity to add gains to capital without negatively impacting long-term earnings. The sale of securities was also used to fund loan growth. Residential mortgage loan activity during the first nine months of 2014 generated $6.1 million of income from the gain on sale of mortgage loans, down $1.5 million from the same period in 2013. This decrease was due to a decrease in volume, partially offset by an increase in the percentage earned on the sale of these loans. Loans originated for sale during the first nine months of 2014 were $164.6 million compared to $289.8 million for the same period in 2013. Mortgage servicing net of impairment decreased by $257,000 compared to the previous year primarily due to an increase in amortization expense as of a result of loans being refinanced.
The following is a summary of changes in non-interest expense (table dollar amounts in thousands):
Non-interest expense
Salaries
Commission and bonuses
Employee benefits
FDIC deposit insurance
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Total non-interest expenses were $1.3 million higher in the third quarter of 2014 compared to the same period of 2013. Salaries increased $448,000 compared to the same period of 2013 primarily due to changes in annual merit pay and a larger employee base. Net occupancy expenses increased $232,000 primarily due to the addition of Summit. Data processing expense increased during the quarter by $141,000 due to growth in services. Outside services and consultants increased by $159,000 compared to the same period of 2013 due to $124,000 in fees associated with the Summit acquisition incurred during the third quarter of 2014. Loan expense increased $162,000 due to an increase in loan origination costs, indirect dealer fees and collection and workout costs. Other expenses increased $123,000 in the third quarter of 2014 compared to the same period in 2013 primarily due to the Company’s growth and expansion efforts.
Total non-interest expenses were $3.4 million higher in the first nine months of 2014 compared to the same period of 2013. Salaries and employee benefits increased $1.3 million and $303,000, respectively, due to changes in annual merit pay and a larger employee base. Commission and bonuses decreased $576,000 due to lower commissions earned as a result of a decrease in mortgage loans originated. Net occupancy expenses increased $410,000 primarily due to the Summit acquisition. Data processing expense increased $530,000 compared to the same period in 2013 due to growth in services and $196,000 in one-time fees associated with the Summit acquisition. Outside services and consultants increased by $920,000 compared to the same period of 2013 due to $1.0 million in fees associated with the Summit acquisition which occurred during the first nine months of 2014. Other expenses increased $515,000 primarily due to the Company’s growth and expansion efforts.
Income Taxes
Income tax expense for the third quarter of 2014 was $1.7 million compared to $1.6 million for same period of 2013. The effective tax rate for the third quarter of 2014 was 26.0% compared to 25.4% in the same period of 2013.
Income tax expense for the nine months ended September 30, 2014 was $4.5 million compared to $6.0 million for same period of 2013. The effective tax rate for the first nine months of 2014 was 25.5% compared to 27.4% in the same period of 2013. The decrease in the effective tax rate is primarily due to lower net income during the nine months ended September 30, 2014 compared to the same period of 2013.
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Liquidity
The Bank maintains a stable base of core deposits provided by long-standing relationships with individuals and local businesses. These deposits are the principal source of liquidity for Horizon. Other sources of liquidity for Horizon include earnings, loan repayment, investment security sales and maturities, proceeds from the sale of residential mortgage loans, and borrowing relationships with correspondent banks, including the FHLB. During the nine months ended September 30, 2014, cash and cash equivalents increased by approximately $5.6 million. At September 30, 2014, in addition to liquidity available from the normal operating, funding, and investing activities of Horizon, the Bank had approximately $284.0 million in unused credit lines with various money center banks, including the FHLB and the FRB Discount Window compared to $311.8 million at December 31, 2013 and $328.9 million at September 30, 2013.
Capital Resources
The capital resources of Horizon and the Bank exceeded regulatory capital ratios for “well capitalized” banks at September 30, 2014. Stockholders’ equity totaled $189.8 million as of September 30, 2014, compared to $164.5 million as of December 31, 2013. For the three months ended September 30, 2014, the ratio of average stockholders’ equity to average assets was 9.33% compared to 9.46% for the three months ended December 31, 2013. The increase in stockholders’ equity during the period was the result of the generation of net income, an increase in accumulated other comprehensive income and common stock issued in the Summit acquisition, net of dividends declared.
The Company currently intends to continue its participation in the Small Business Lending Fund, pursuant to which it issued preferred stock to the US Treasury, since the growth in the Company’s small business lending has reduced the dividend cost. For the three months ending September 30, 2014, the dividend cost was approximately $40,000, or 1.3% annualized. For both the fourth quarter of 2014 and the first quarter of 2015, the dividend cost will be approximately $31,250, or 1.0%. The Company plans to reserve cash for the ability to redeem this preferred stock if and when the cost of this capital exceeds other forms of capital, subject to regulatory approval.
Horizon declared common stock dividends in the amount of $0.37 per share during the first nine months of 2014 compared to $0.31 per share for the same period of 2013. The dividend payout ratio (dividends as a percent of basic earnings per share) was 25.5% and 17.3% for the first nine months of 2014 and 2013, respectively. For additional information regarding dividends, see Horizon’s Annual Report on Form 10-K for 2013.
Basel III
On July 2, 2013, the Board of Governors of the Federal Reserve System announced its approval of the final rule to implement the Basel III regulatory capital reforms, among other changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Office of the Comptroller of the Currency, as well as the Federal Deposit Insurance Corporation, adopted the new rule on July 9, 2013. The final approved rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% as well as a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking institutions
The phase-in for banking organizations such as Horizon and the Bank will not begin until January 2015, while the phase-in period for larger banks started in January 2014. Horizon and the Bank are currently evaluating the impact of the implementation of the new capital and liquidity standards.
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Use of Non-GAAP Financial Measures
Certain information set forth in this quarterly report on Form 10-Q refers to financial measures determined by methods other than in accordance with GAAP. Specifically, we have included non-GAAP financial measures of the net interest income and net interest margin excluding the impact of acquisition-related purchase accounting adjustments and net income and diluted earnings per share excluding the impact of one-time costs related to the Summit acquisition. Horizon believes these non-GAAP financial measures are helpful to investors and provide a greater understanding of our business without giving effect to the purchase accounting impacts and one-time costs of acquisitions, although these measures are not necessarily comparable to similar measures that may be presented by other companies and should not be considered in isolation or as a substitute for the related GAAP measure.
Non-GAAP Reconciliation of Net Interest Margin
(Dollar Amounts in Thousands, Unaudited)
Net Interest Margin As Reported
Net interest income
Average interest-earning assets
Net interest income as a percent of average interest earning assets
Impact of Acquisitions
Interest income from acquisition-related purchase accounting adjustments
Net Interest Margin Excluding Impact of Acquisitions
Non-GAAP Reconciliation of Net Income and Diluted Earnings per Share
(Dollar Amounts in Thousands Except per Share Data, Unaudited)
Non-GAAP Reconciliation of Net Income
Net income as reported
Summit expenses
Tax Effect
Net income excluding Summit expenses
Non-GAAP Reconciliation of Diluted Earnings per Share
Diluted earnings per share as reported
Diluted earnings per share excluding Summit expenses
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Quantitative and Qualitative Disclosures About Market Risk
We refer you to Horizon’s 2013 Annual Report on Form 10-K for analysis of its interest rate sensitivity. Horizon believes there have been no significant changes in its interest rate sensitivity since it was reported in its 2013 Annual Report on Form 10-K.
Evaluation Of Disclosure Controls And Procedures
Based on an evaluation of disclosure controls and procedures as of September 30, 2014, Horizon’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of Horizon’s disclosure controls (as defined in Exchange Act Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on such evaluation, such officers have concluded that, as of the evaluation date, Horizon’s disclosure controls and procedures are effective to ensure that the information required to be disclosed by Horizon in the reports it files under the Exchange Act is recorded, processed, summarized and reported within the time specified in Securities and Exchange Commission rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding disclosure.
Changes In Internal Control Over Financial Reporting
Horizon’s management, including its Chief Executive Officer and Chief Financial Officer, also have concluded that during the fiscal quarter ended September 30, 2014, there have been no changes in Horizon’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, Horizon’s internal control over financial reporting.
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Part II – Other Information
Horizon and its subsidiaries are involved in various legal proceedings incidental to the conduct of their business. Management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
There have been no material changes from the factors previously disclosed under Item 1A of Horizon’s Annual Report on Form 10-K for 2013.
Not Applicable
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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.
/s/ Craig M. Dwight
/s/ Mark E. Secor
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INDEX TO EXHIBITS
Exhibit No.
Description
Location
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