Peoples Bancorp - 10-Q quarterly report FY

FORM 10-Q

 

 

 

The accounting and reporting policies followed in the presentation of the accompanying Unaudited Consolidated Financial Statements are consistent with those described in Note 1 of the Notes to the Consolidated Financial Statements included in Peoples’ 2008 Form 10-K, as updated by the information contained in this Form 10-Q.  Management has evaluated all significant events and transactions that occurred after September 30, 2009, but prior to October 22, 2009, the date these consolidated financial statements were issued, for potential recognition or disclosure in these consolidated financial statements.  In the opinion of management, these consolidated financial statements reflect all adjustments necessary to present fairly such information for the periods and dates indicated.  Such adjustments are normal and recurring in nature.  All significant intercompany accounts and transactions have been eliminated.  The Consolidated Balance Sheet at December 31, 2008, contained herein has been derived from the audited Consolidated Balance Sheets included in Peoples’ 2008 Form 10-K.

 

The preparation of the consolidated financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes.  Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year, due in part to seasonal variations and unusual or infrequently occurring items.  Peoples’ results of operations for the three and nine months ended September 30, 2009, were impacted by the recognition of FDIC insurance expense of $930,000 ($605,000 after-tax) associated with a special assessment imposed on all FDIC-insured depository institutions as of June 30, 2009.  This special assessment was collected on September 30, 2009.  In addition, Peoples’ insurance income includes contingent performance based insurance commissions that are recognized by Peoples when received, which typically occurs during the first quarter of each year.

 

 

Common stock warrants are evaluated for liability or equity treatment.  The common stock warrant outstanding is carried in stockholders’ equity until exercised or expired based on the view of both the SEC and Financial Accounting Standards Board (the “FASB”) that they would not object to classification of such warrants as permanent equity.  This view is consistent with the objective of the Capital Purchase Program that equity in these securities should be considered part of equity for regulatory reporting purposes.  The fair value of the common stock warrant used in allocating total proceeds received was determined based on a binomial model.

 

 

On June 12, 2009, the FASB issued two related accounting pronouncements changing the accounting principles and disclosures requirements related to securitizations and special-purpose entities.  Specifically, these pronouncements eliminate the concept of a “qualifying special-purpose entity”, change the requirements for derecognizing financial assets and change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated.  These pronouncements also expand existing disclosure requirements to include more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets.  These pronouncements will be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  The recognition and measurement provisions regarding transfers of financial assets shall be applied to transfers that occur on or after the effective date.  Peoples will adopt these new pronouncements on January 1, 2010, as required.  Management has not yet determined the impact adoption may have on Peoples’ consolidated financial statements.

 

On May 28, 2009, the FASB issued an accounting pronouncement establishing general standards of accounting for and disclosure of subsequent events, which are events occurring after the balance sheet date but before the date the financial statements are issued or available to be issued.  In particular, the pronouncement requires entities to recognize in the financial statements the effect of all subsequent events that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process.  Entities may not recognize the impact of subsequent events that provide evidence about conditions that did not exist at the balance sheet date but arose after that date.  This pronouncement also requires entities to disclose the date through which subsequent events have been evaluated.  This pronouncement was effective for interim and annual reporting periods ending after June 15, 2009.  Peoples adopted the provisions of this pronouncement for the quarter ended June 30, 2009, as required, and adoption did not have a material impact on Peoples’ financial statements taken as a whole.

 

On April 9, 2009, the FASB issued three related accounting pronouncements intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities.  In particular, these pronouncements: (1) provide guidelines for making fair value measurements more consistent with the existing accounting principles when the volume and level of activity for the asset or liability have decreased significantly; (2) enhance consistency in financial reporting by increasing the frequency of fair value disclosures and (3) modify existing general standards of accounting for and disclosure of other-than-temporary impairment (“OTTI”) losses for impaired debt securities.

 

The fair value measurement guidance of these pronouncements reaffirms the need for entities to use judgment in determining if a formerly active market has become inactive and in determining fair values when markets have become inactive.  The changes to fair value disclosures relate to financial instruments that are not currently reflected on the balance sheet at fair value.  Prior to these pronouncements, fair value disclosures for these instruments were required for annual statements only.  These disclosures now are required to be included in interim financial statements.  The general standards of accounting for OTTI losses were changed to require the recognition of an OTTI loss in earnings only when an entity (1) intends to sell the debt security; (2) more likely than not will be required to sell the security before recovery of its amortized cost basis or (3) does not expect to recover the entire amortized cost basis of the security.  In situations when an entity intends to sell or more likely than not will be required to sell the security, the entire OTTI loss must be recognized in earnings.  In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in other comprehensive income, net of deferred taxes.

 

All three pronouncements were effective for interim and annual periods ending after June 15, 2009.  Entities were permitted to early adopt the provisions of these pronouncements for interim and annual periods ending after March 15, 2009, but had to adopt all three concurrently.  Peoples adopted these provisions of these pronouncements for the quarterly period ending June 30, 2009, as required.  As a result of adoption, Peoples recorded a cumulative effect adjustment on April 1, 2009, which increased retained earnings by $304,000, net of tax, for the non-credit portion of previously recorded OTTI losses, with a corresponding reduction in accumulated comprehensive income (loss) included in stockholders’ equity on the Consolidated Balance Sheet.  The adoption of the remaining provisions of these pronouncements did not have any material impact on Peoples’ financial statements taken as a whole.

 

The measurement of fair value under US GAAP uses a hierarchy intended to maximize the use of observable inputs and minimize the use of unobservable inputs.  This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

 

Level 1: Quoted prices in active exchange markets for identical assets or liabilities; also includes certain U.S. Treasury and other U.S. government and agency securities actively traded in over-the-counter markets.

 

Level 2: Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data.  This category generally includes certain U.S. government and agency securities, corporate debt securities, derivative instruments, and residential mortgage loans held for sale.

 

Level 3: Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs for single dealer nonbinding quotes not corroborated by observable market data. This category generally includes certain private equity investments, retained interests from securitizations, and certain collateralized debt obligations.

 

Assets measured at fair value on a recurring basis comprised the following at September 30, 2009:

 

 

The investment securities measured at fair value utilizing Level 1 and Level 2 inputs are obligations of the U.S. Treasury, agencies and corporations of the U.S. government, including mortgage-backed securities, bank eligible obligations of any state or political subdivision in the U.S., bank eligible corporate obligations, including private-label mortgage-backed securities and common stocks issued by various unrelated banking holding companies.  The fair values used by Peoples are obtained from an independent pricing service and represent either quoted market prices for the identical securities (Level 1 inputs) or fair values determined by pricing models that consider observable market data, such as interest rate volatilities, LIBOR yield curve, credit spreads and prices from market makers and live trading systems.

 

The investment securities measured at fair value using Level 3 inputs are comprised of four collateralized debt obligations, with a total book value of $2.8 million, and a single corporate obligation, with a book value of $1.0 million, for which there is not an active market.  Peoples uses multiple input factors to determine the fair value of these securities.  Those input factors are discounted cash flow analysis, structure of the security in relation to current level of deferrals and/or defaults, changes in credit ratings, financial condition of the debtors within the underlying securities, broker quotes for securities with similar structure and credit risk, interest rate movements and pricing of new issuances.

 

The following is a reconciliation of activity for assets measured at fair value based on significant unobservable (non-market) information:

 

 

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).  Financial assets measured at fair value on a non-recurring basis included the following:

 

Impaired Loans: Impaired loans are measured and reported at fair value when management believes collection of contractual interest and principal payments is doubtful.  Management’s determination of the fair value for these loans represents the estimated net proceeds to be received from the sale of the collateral based on observable market prices and market value provided by independent, licensed or certified appraisers (Level 2 Inputs).  At September 30, 2009, impaired loans with an aggregate outstanding principal balance of $27.1 million were measured and reported at a fair value of $21.2 million.  During the three months and nine months ended September 30, 2009, Peoples recognized losses on impaired loans of $10.0 million and $15.1 million, respectively, through the allowance for loan losses.

 

The following table presents the fair values of financial assets and liabilities carried on Peoples’ consolidated balance sheet, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis:

 

The methodologies for estimating the fair value of financial assets and liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above.  For certain financial assets and liabilities, carrying value approximates fair value due to the nature of the financial instrument.  These instruments include cash and cash equivalents, demand and other non-maturity deposits and overnight borrowings.  Peoples used the following methods and assumptions in estimating the fair value of the following financial instruments:

 

Loans: The fair value of performing variable rate loans that reprice frequently and performing demand loans, with no significant change in credit risk, is based on carrying value.  The fair value of fixed rate performing loans is estimated using discounted cash flow analyses and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

 

 

Deposits: The fair value of fixed maturity certificates of deposit is estimated using a discounted cash flow calculation based on current rates offered for deposits of similar remaining maturities.

 

Short-term Borrowings: The fair value of term national market repurchase agreements is estimated using a discounted cash flow calculation based on rates currently available to Peoples for repurchase agreements with similar terms.

 

Long-term Borrowings: The fair value of long-term borrowings is estimated using discounted cash flow analysis based on rates currently available to Peoples for borrowings with similar terms.

 

Junior Subordinated Notes Held by Subsidiary Trust: The fair value of the junior subordinated notes held by subsidiary trust is estimated using discounted cash flow analysis based on current market rates of securities with similar risk and remaining maturity.

 

Bank premises and equipment, customer relationships, deposit base, banking center networks, and other information required to compute Peoples’ aggregate fair value are not included in the above information.  Accordingly, the above fair values are not intended to represent the aggregate fair value of Peoples.

 

 

At September 30, 2009, there were no securities of a single issuer, other than U.S. Treasury and government agencies and U.S. government sponsored agencies that exceeded 10% of stockholders' equity.  Investment securities having a carrying value of $627.4 million and $619.3 million at September 30, 2009 and December 31, 2008, respectively, were pledged to secure public and trust department deposits and repurchase agreements in accordance with federal and state requirements.

 

The gross gains and gross losses realized by Peoples from sales of available-for-sale securities for the three and nine months ended September 30 were as follows:

 

 

The cost of investment securities sold, and any resulting gain or loss, was based on the specific identification method and recognized as of the trade date.

 

The following table presents a summary of available-for-sale investment securities that had an unrealized loss:

 

The unrealized losses at both September 30, 2009 and December 31, 2008, were attributable to changes in market interest rates since the securities were purchased.  Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis.  This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers, (3) structure of the security and (4) Peoples’ intent to sell the security or whether it is more likely than not that Peoples would be required to sell the security before its anticipated recovery in market value.

 

At September 30, 2009, management concluded an individual bank-issued trust preferred security, with a book value of $4.0 million, and a single mezzanine tranche CDO, with a book value of $2.7 million, were other-than-temporarily impaired.  These determinations reflected management’s evaluation of the underlying credit quality of the securities and estimations of cash flows expected to be collected from the securities, which indicated it was probable Peoples would not recover the entire amortized cost of the securities.  As a result, Peoples recognized a non-cash impairment loss of $5.9 million ($3.9 million after-tax) in earnings for the three months ended September 30, 2009, of which $4.0 million related to the individual bank-issued trust preferred security and $1.9 million related to the mezzanine tranche CDO.  This impairment loss represents management’s estimate of credit losses incurred during the third quarter of 2009.  Since Peoples does not intend to sell, nor is it more likely than not that Peoples will be required to sell, the security prior to recovery, the non-credit component was recognized in other comprehensive income.

 

The measurement of the credit loss incurred on the mezzanine tranche CDO was based upon management’s estimation of future cash flows versus the cash flows projected previously.  In estimating future cash flows, management considers the structure and term of the pool and the financial condition of the underlying issuers.  Specifically, the evaluation incorporates factors such as over-collateralization and interest coverage tests, interest rates and appropriate risk premiums, the timing and amount of interest and principal payments and the allocation of payments to the various tranches.  Current estimates of cash flows are based on the recent trustee reports, announcements of deferrals or defaults and assumptions regarding expected future default rates, prepayment and recovery rates and other relevant information.  Additionally, management considers the impact on future cash flows should institutions identified as possessing a higher probability of default, based upon an evaluation of performance metrics, were to default in the near term.  Key assumptions used include: (1) current defaults would have no recovery and (2) current deferrals considered as defaults with no expected recovery.

 

Management performed its quarterly analysis of the remaining securities with an unrealized loss at September 30, 2009, and concluded no other individual securities were other-than-temporarily impaired.

 

The following table summarizes the roll-forward of cumulative credit losses on available-for-sale securities for which a portion of an other-than-temporary impairment is recognized in other comprehensive income, including those securities for which a cumulative effect adjustment was recorded:

 

The following table presents the amortized costs, fair value and weighted-average yield of securities by contractual maturity at September 30, 2009.  The average yields are based on the amortized cost.  In some cases, the issuers may have the right to call or prepay obligations without call or prepayment penalties prior to the contractual maturity date.  Rates are calculated on a fully tax-equivalent basis using a 35% federal income tax rate.

 

 

Peoples’ other investment securities on the Consolidated Balance Sheets consist solely of restricted equity securities of the Federal Home Loan Bank (“FHLB”) of Cincinnati and the Federal Reserve Bank of Cleveland.  These securities are carried at cost since they do not have readily determinable fair values due to their restricted nature and Peoples does not exercise significant influence.

 

The following table details the progression in shares of Peoples’ preferred, common and treasury stock during the period presented:

 

Under its Amended Articles of Incorporation, Peoples is authorized to issue up to 50,000 preferred shares, in one or more series, having such voting powers, designations, preferences, rights, qualifications, limitations and restrictions as determined by the Board of Directors.  On January 28, 2009, Peoples’ Board of Directors created a series of preferred shares designated as Peoples’ Fixed Rate Cumulative Perpetual Preferred Shares, Series A, each without par value and having a liquidation preference of $1,000 per share, and fixed 39,000 shares as the authorized number of such shares (the “Series A Preferred Shares”).

 

On January 30, 2009, Peoples issued and sold to the United States Department of the Treasury (the “U.S. Treasury”) (i) 39,000 of Peoples’ Series A Preferred Shares, and (ii) a ten-year warrant (the “Warrant”) to purchase 313,505 Peoples common shares, at an exercise price of $18.66 per share (subject to certain anti-dilution and other adjustments), for an aggregate purchase price of $39 million in cash.

 

The Series A Preferred Shares accrue cumulative quarterly dividends at a rate of 5% per annum from January 30, 2009 to, but excluding February 15, 2014, and 9% per annum thereafter.  These dividends will be paid only if, as and when declared by Peoples’ Board of Directors.  The Series A Preferred Shares have no maturity date and rank senior to the common shares with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of Peoples.  Peoples has the option to redeem the Series A Preferred Shares at 100% of their liquidation preference plus accrued and unpaid dividends, subject to the approval of the Board of Governors of the Federal Reserve System and the Office of the Comptroller of Currency.  The Series A Preferred Shares are generally non-voting.

 

The U.S. Treasury may not transfer a portion or portions of the Warrant with respect to, and/or exercise the Warrant for more than one-half of, the 313,505 common shares issuable upon exercise of the Warrant, in the aggregate, until the earlier of (i) the date on which Peoples has received aggregate gross proceeds of not less than $39 million from one or more Qualified Equity Offerings and (ii) December 31, 2009.  However, if Peoples were to redeem all of the Series A Preferred Shares as permitted by and in accordance with the provisions of the American Recovery and Reinvestment Act and the documents required to consummate the redemption, Peoples has the option to repurchase the Warrant from the U.S. Treasury.  If Peoples declines to repurchase the Warrant, the U.S. Treasury will be permitted, subject to compliance with applicable securities laws, to transfer all or a portion of the Warrant with respect to, and/or exercise the Warrant for, all or a portion of the number of common shares issuable thereunder, at any time and without limitation.  In the event Peoples completes one or more Qualified Equity Offerings on or prior to December 31, 2009, that result in Peoples receiving aggregate gross proceeds of not less than $39 million, the number of the common shares underlying the portion of the Warrant then held by the U.S. Treasury will be reduced by one-half of the common shares originally covered by the Warrant.  The U.S. Treasury has agreed not to exercise voting power with respect to any common shares issued to it upon exercise of the Warrant.  Any common shares issued by Peoples upon exercise of the Warrant will be issued from common shares held in treasury to the extent available.  If no treasury shares are available, common shares will be issued from authorized but unissued common shares.  At September 30, 2009, there had been no changes to the number of common shares covered by the Warrant nor had the U.S. Treasury exercised any portion of the Warrant.

 

The proceeds received from the U.S. Treasury were allocated to the Series A Preferred Shares and the Warrant based on relative fair value.  The fair value of the Series A Preferred Shares was determined through a discounted future cash flow model at a discount rate of 14%.  The fair value of the Warrant was calculated using a binomial option pricing model, which includes assumptions regarding Peoples’ dividend yield, stock price volatility, and the risk-free interest rate.  The relative fair value of the Series A Preferred Shares and the Warrant on January 30, 2009, was $38.5 million and $0.5 million, respectively.

 

Peoples calculated a discount on the Series A Preferred Shares in the amount of $0.5 million, which is being amortized over a 5-year period.  The effective yield on the amortization of the Series A Preferred Shares is approximately 5.32%.  In determining net income available to common shareholders, the periodic amortization and the cash dividend on the preferred stock are subtracted from net income.  For the nine months ended September 30, 2009, Peoples accrued dividends and recorded amortization on Series A Preferred Shares for $1,300,000 and $64,000, respectively.

 

The following details the change in the components of Peoples’ accumulated other comprehensive (loss) income for the nine months ended September 30, 2009:

 

The components of other comprehensive income (loss) for the three and nine months ended September 30 were as follows:

 

Peoples sponsors a noncontributory defined benefit pension plan that covers substantially all employees.  The plan provides retirement benefits based on an employee’s years of service and compensation.  In 2003, Peoples changed the methodology used to determine the retirement benefits for employees hired on or after January 1, 2003, which has lowered accumulated benefit obligations and net costs.  Peoples also has a contributory postretirement benefit plan for former employees who were retired as of December 31, 1992.  The plan provides health and life insurance benefits.  Peoples’ policy is to fund the cost of the benefits as they are incurred.  The following table details the components of the net periodic benefit cost for the plans:

Through September 30, 2009, Peoples contributed $1.2 million to its pension plan upon the recommendation of and approval by the Board of Directors, which were designated for the 2008 plan year.

 

Peoples and Peoples Bank’s actual capital amounts and ratios are presented in the following table:

                  (1)  Ratio represents total capital to net risk-weighted assets

                  (2)  Ratio represents Tier 1 capital to net risk-weighted assets

                  (3)  Ratio represents Tier 1 capital to average assets

Under the Peoples Bancorp Inc. Amended and Restated 2006 Equity Plan (the “2006 Equity Plan”), Peoples may grant, among other awards, nonqualified stock options, incentive stock options, restricted stock awards, stock appreciation rights or any combination thereof covering up to 500,000 common shares to employees and non-employee directors.  Prior to 2007, Peoples granted nonqualified and incentive stock options to employees and nonqualified stock options to non-employee directors under the 2006 Equity Plan and predecessor plans.  Since February 2007, Peoples has granted a combination of restricted common shares and stock appreciation rights (“SARs”) to be settled in common shares to employees and restricted common shares to non-employee directors subject to the terms and conditions prescribed by the 2006 Equity Plan.  During the nine-month period ending September 30, 2009, Peoples did not grant any stock-based compensation awards to employees or non-employee directors and no outstanding stock options or SARs were exercised.

 

In general, common shares issued in connection with stock-based awards are issued from treasury shares to the extent available.  If no treasury shares are available, common shares are issued from authorized but unissued common shares.

 

Peoples recognized stock-based compensation expense, which is included as a component of Peoples’ salaries and employee benefits costs, based on the estimated fair value of the awards on the grant date.  The following summarizes the amount of stock-based compensation expense and related tax benefit recognized for the period ended September 30:

 

Total unrecognized stock-based compensation expense related to unvested awards was $100,000 at September 30, 2009, which will be recognized over a weighted-average period of 1.1 years.

 

Basic earnings per common share are computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding.  Diluted earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding adjusted to include the effect of potentially dilutive common shares.  Potentially dilutive common shares include incremental shares issuable upon exercise of outstanding stock options, SARs and non-vested restricted common shares using the treasury stock method.  As disclosed in Note 4, Peoples had a warrant to purchase 313,505 common shares outstanding at September 30, 2009.  This warrant was excluded from the calculation of diluted earnings per common share since it was anti-dilutive.  In addition, stock options and SARs covering 286,355 shares and 284,673 shares were excluded from the calculations for the three and nine month ended September 30, 2009, respectively, since they were anti-dilutive.  The calculation of basic and diluted earnings per common share was as follows:

 

 

The following data should be read in conjunction with the Unaudited Consolidated Financial Statements and Management’s Discussion and Analysis that follows:

Certain statements in this Form 10-Q which are not historical fact are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995.  Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements.  Forward-looking statements are subject to risks and uncertain­ties that may cause actual results to differ materially.  Factors that might cause such a difference include, but are not limited to:

All forward-looking statements speak only as of the execution date of this Form 10-Q and are expressly qualified in their entirety by the cautionary statements.  Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections.  Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements.  Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples Bancorp Inc.’s website – www.peoplesbancorp.com under the “Investor Relations” section.

 

This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements, and notes thereto, contained in Peoples’ 2008 Form 10-K, as well as the Unaudited Consolidated Financial Statements, ratios, statistics and discussions contained elsewhere in this Form 10-Q.

 

 

The following discussion and analysis of Peoples’ Unaudited Consolidated Financial Statements is presented to provide insight into management’s assessment of the financial condition and results of operations.

 

Peoples offers diversified financial products and services through 47 financial service locations and 39 ATMs in southeastern Ohio, northwestern West Virginia and northeastern Kentucky through its financial service units – Peoples Bank, National Association (“Peoples Bank”), Peoples Financial Advisors (a division of Peoples Bank) and Peoples Insurance Agency, Inc, a subsidiary of Peoples Bank.  Peoples Bank is a member of the Federal Reserve System and subject to regulation, supervision and examination by the Office of the Comptroller of the Currency.

 

Peoples’ products and services include traditional banking products, such as deposit accounts, lending products and trust services.  Peoples also offers a complete array of insurance products and makes available custom-tailored fiduciary and wealth management services.  Peoples provides services through traditional offices, ATMs and telephone and internet-based banking.  Brokerage services are offered exclusively through an unaffiliated registered broker-dealer located at Peoples’ offices.

 

 

The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry.  The preparation of the financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could materially differ from those estimates.  Management has identified the accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of Peoples’ Consolidated Financial Statements and Management’s Discussion and Analysis at September 30, 2009, which were unchanged from the policies disclosed in Peoples’ 2008 Form 10-K.

 

Goodwill and Other Intangible Assets

In prior years, Peoples completed various mergers and acquisitions, which have resulted in the recognition of goodwill and other intangible assets on the Consolidated Balance Sheet.  As more fully discussed in Peoples’ 2008 Form 10-K, goodwill is not amortized but is tested for impairment at least annually and updated quarterly if management believes there are indicators of potential impairment.  The initial value of goodwill relates to the inherent value of acquired business, including the potential net revenue stream generated by Peoples from the acquired business.  As such, a sustained decline in earnings can lead to impairment of goodwill, which could adversely impact Peoples’ earnings in future periods.

 

At June 30, 2009, management performed its annual impairment test of Peoples’ recorded goodwill and concluded no impairment existed.  This analysis further indicated a 20-25% sustained decline in future earnings would have to occur for any recorded goodwill to be considered impaired.  Given the impact of higher loan loss provisions and investment securities impairment losses on third quarter 2009 results, management reviewed Peoples’ recorded goodwill at September 30, 2009, for indicators of potential impairment.  As part of this review, management estimated the fair value of Peoples’ single reporting unit using a discounted cash flow analysis and concluded no impairment existed since the fair value of the single reporting unit exceeded its carrying value by approximately 16%.  Additionally, management’s September 30 analysis indicated a 15% sustained decline in future earnings would have to occur in order for any recorded goodwill to become impaired.

 

 

As a financial services company, the carrying value of certain financial assets and liabilities of Peoples is impacted by the application of fair value measurements, either directly or indirectly.  Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period.  There were no material changes to the accounting practices and valuation methodologies employed by Peoples related to fair value measurements from those disclosed in Peoples’ 2008 Form 10-K.

 

 

The following is a summary of recent transactions or events that have impacted or are expected to impact Peoples’ results of operations or financial condition:

 

 

 

 

 

 

 

 

 

 

 

 

The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis.

 

 

In the third quarter of 2009, the combination of higher provision for loan losses and other-than-temporary impairment charges on investment securities resulted in Peoples incurring a net loss available to common shareholders of $4.6 million, or $0.44 per diluted common share.  In comparison, net income available to common shareholders was $2.4 million for the second quarter of 2009 (or “linked quarter”) and $3.0 million for the third quarter of 2008, while earnings per diluted common share were $0.23 and $0.28, respectively.  On a year-to-date basis, net income available to common shareholders was $1.6 million through September 30, 2009 versus $10.6 million a year ago, while diluted earnings per common share were $0.16 and $1.02, respectively.

 

Peoples recorded a provision for loan losses of $10.2 million versus $4.7 million in the linked quarter and $6.0 million in the third quarter of 2008.  These provisions reflect the amounts needed to maintain the adequacy of the allowance for loan losses based on management’s formal quarterly analysis.  The higher provision for loan losses in the third quarter of 2009 was largely attributable to declines in commercial real estate values securing existing impaired loans, coupled with the impact of loan downgrades.

 

In the third quarter of 2009, net interest income totaled $15.5 million, comparable to the linked quarter, and net interest margin was unchanged at 3.45%.  Interest income decreased slightly due to loan payoffs and additional loans placed on nonaccrual status.  This reduction was offset by decreased interest expense from lower overall cost of funds attributable to Peoples repaying maturing, high-cost borrowings.  For both the three and nine months ended September 30, 2009, net interest income increased 6% compared to the prior year periods, while net interest margin decreased 5 basis points compared to the third quarter of 2008 and 7 basis points on a year-to-date basis.

 

Non-interest income, which excludes gains and losses on securities and asset disposals, experienced a modest 6% linked quarter decrease, due mostly to lower mortgage banking income from a decline in refinancing activity.  Year-over-year, non-interest income was down 5% in the third quarter primarily attributable to lower insurance revenues and reduced bank owned life insurance (“BOLI”) income.  On a year-to-date basis, higher mortgage banking revenue and increased deposit account service charges were offset by reductions in trust and investment revenues and BOLI income, resulting in consistent total non-interest income.

 

Third quarter 2009 non-interest expense decreased 6% on a linked quarter basis, attributable to significantly lower FDIC insurance expense and incentive-related compensation costs.  Compared to the prior year periods, total non-interest expense increased for both the three and nine months ended September 30, 2009, due mostly to additional FDIC insurance expense and external legal and valuation expenses associated with problem loans.  Other significant contributing factors included higher employee medical benefit and pension plan costs.

 

At September 30, 2009, total assets were down $34.5 million compared to $2.04 billion at June 30, 2009, as excess cash reserves held at the Federal Reserve Bank were used to reduce non-core deposits and borrowed funds.  Gross portfolio loan balances decreased $26.1 million in the third quarter of 2009, due mostly to commercial loan payoffs and charge-downs on existing impaired loans.  Contributing to the $36.0 million decline since year-end 2008 was the impact of residential real estate loans being refinanced and sold to the secondary market.  At September 30, 2009, total investment securities were up $32.1 million for the quarter and $41.5 million since December 31, 2008, primarily attributable to an increase in fair value of the portfolio.

 

Total liabilities were $1.76 billion at September 30, 2009, down $40.4 million compared to June 30, 2009 and down $55.3 million compared to December 31, 2008.  Total deposit balances decreased $14.0 million during the third quarter to $1.39 billion at quarter-end, due largely to a planned reduction in non-core deposits.  However, total deposits remained $27.2 million higher than year-end 2008, due to strong growth in low-cost and non-interest-bearing retail deposits and $17.3 million of additional brokered deposits.  Total borrowed funds were $348.0 million at September 30, 2009, versus $373.5 million at June 30, 2009, with repayment of long-term borrowings accounting for nearly all of the decrease.  Through nine months of 2009, the combination of retail deposit growth and funds generated from the TARP Capital Investment enabled Peoples to reduce total borrowed funds $81.7 million, or 19%.  The reduction in borrowings included the elimination of overnight wholesale borrowings, which totaled $44.4 million at December 31, 2008.

 

Total stockholders’ equity increased $5.9 million and $57.7 million for the three and nine months ended September 30, 2009, respectively.  The key driver of the linked quarter increase was an $11.3 million increase in fair value of Peoples’ available-for-sale investment portfolio, net of deferred tax.  The TARP Capital Investment accounted for most of the year-to-date growth, while the fair value of the available-for-sale investment portfolio increased $21.9 million, net of deferred tax, further contributing to higher stockholders’ equity at September 30, 2009.

 

 

 

Net interest income, the amount by which interest income exceeds interest expense, remains Peoples’ largest source of revenue.  The amount of net interest income earned by Peoples each quarter is affected by various factors, including changes in market interest rates due to the Federal Reserve Board’s monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples’ markets, and the amount and composition of Peoples’ earning assets and interest-bearing liabilities.

 

The following table details Peoples’ average balance sheets for the periods presented: