UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 or 15 (d) of THE SECURITIES EXCHANGE ACT OF 1934 For Quarterly Period Ended March 31, 2002 Commission File Number 0-17071 First Merchants Corporation (Exact name of registrant as specified in its charter) Indiana 35-1544218 (State or other jurisdiction of (I.R.S. Employer incorporation of organization) Identification No.) 200 East Jackson Street Muncie, IN 47305-2814 (Address of principal executive office) (Zip code) (765) 747-1500 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] As of April 30, 2002 there were 15,569,585 outstanding common shares, without par value, of the registrant.
FIRST MERCHANTS CORPORATION FORM 10-Q INDEX Page No. PART I. Financial information: Item 1. Financial Statements: Consolidated Condensed Balance Sheets........................3 Consolidated Condensed Statements of Income..................4 Consolidated Condensed Statements of Comprehensive Income.........................................5 Consolidated Condensed Statements of Stockholders' Equity.........................................6 Consolidated Condensed Statements of Cash Flows..............7 Notes to Consolidated Condensed Financial Statements.........9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................15 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................................23 PART II. Other Information: Item 1. Legal Proceedings...........................................24 Item 2. Changes in Securities and Use of Proceeds...................24 Item 3. Defaults Upon Senior Securities.............................24 Item 4. Submission of Matters to a Vote of Security Holders.........24 Item 5. Other Information...........................................24 Item 6. Exhibits and Reports of Form 8-K............................24 Signatures ............................................................25 Page 2
FIRST MERCHANTS CORPORATION FORM 10-Q PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS CONSOLIDATED CONDENSED BALANCE SHEETS (Dollars in thousands, except per share amounts) <TABLE> March 31, December 31, 2002 2001 ----------- ----------- (Unaudited) <S> <C> <C> ASSETS: Cash and due from banks ....................................... $ 44,059 $ 68,743 Federal funds sold ............................................ 21,194 34,285 ----------- ----------- Cash and cash equivalents ................................... 65,253 103,028 Interest-bearing deposits...................................... 3,818 3,871 Investment securities available for sale ...................... 213,228 231,668 Investment securities held to maturity ........................ 7,133 8,654 Mortgage loans held for sale................................... 163 307 Loans, net of allowance for loan losses of $15,128 and $15,141. 1,348,923 1,344,445 Premises and equipment ........................................ 28,426 27,684 Federal Reserve and Federal Home Loan Bank Stock............... 8,350 8,350 Interest receivable ........................................... 11,356 12,024 Goodwill ...................................................... 27,681 26,081 Core deposit intangibles ...................................... 5,870 6,096 Cash surrender value of life insurance......................... 6,557 6,470 Other assets .................................................. 9,154 8,357 ----------- ----------- Total assets .............................................. $ 1,735,912 $ 1,787,035 =========== =========== LIABILITIES: Deposits: Noninterest-bearing ......................................... $ 171,825 $ 186,987 Interest-bearing ............................................ 1,201,861 1,234,264 ----------- ----------- Total deposits ............................................ 1,373,686 1,421,251 Borrowings .................................................... 164,954 174,404 Interest payable .............................................. 5,621 5,488 Other liabilities.............................................. 8,567 6,764 ----------- ----------- Total liabilities ......................................... 1,552,828 1,607,907 STOCKHOLDERS' EQUITY: Perferred stock, no-par value: Authorized and unissued - 500,000 shares .................... Common Stock, $.125 stated value: Authorized --- 50,000,000 shares ............................ Issued and outstanding - 12,788,037 and 12,670,307 shares.... 1,599 1,584 Additional paid-in capital .................................... 53,338 50,642 Retained earnings ............................................. 126,842 124,304 Accumulated other comprehensive income ........................ 1,305 2,598 ----------- ----------- Total stockholders' equity ................................ 183,084 179,128 ----------- ----------- Total liabilities and stockholders' equity . $ 1,735,912 $ 1,787,035 =========== =========== </TABLE> See notes to consolidated condensed financial statements. Page 3
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF INCOME (Dollars in thousands, except per share amounts) (Unaudited) <TABLE> Three Months Ended March 31, <S> <C> <C> 2002 2001 Interest Income: Loans receivable Taxable ................................................... $ 24,266 $ 25,190 Tax exempt ................................................ 108 92 Investment securities: Taxable ................................................... 1,903 3,539 Tax exempt ................................................ 987 1,027 Federal funds sold .......................................... 181 89 Deposits with financial institutions ........................ 22 10 Federal Reserve and Federal Home Loan Bank stock ............ 124 141 -------- -------- Total interest income ................................... 27,591 30,088 -------- -------- Interest expense: Deposits .................................................... 8,228 12,701 Borrowings .................................................. 1,985 2,698 -------- -------- Total interest expense .................................... 10,213 15,399 -------- -------- Net Interest Income ........................................... 17,378 14,689 Provision for loan losses ..................................... 1,192 653 -------- -------- Net Interest Income After Provision for Loan Losses ........... 16,186 14,036 -------- -------- Other Income: Net realized gains on sales of available-for-sale securities. 118 Other income ................................................ 5,046 4,394 -------- -------- Total other income ............................................ 5,164 4,394 Total other expenses .......................................... 13,000 10,473 -------- -------- Income before income tax ...................................... 8,350 7,957 Income tax expense ............................................ 2,871 2,851 -------- -------- Net Income .................................................... $ 5,479 $ 5,106 ======== ======== Per share: <F1> Diluted Cash Earnings(1)................................... $ .43 $ .44 Basic ..................................................... .43 .42 Diluted ................................................... .43 .42 Dividends ................................................. .23 .23 <FN> (1) Net income excluding core deposit and other intangible assets amortization. Also, excludes goodwill amortization for the three months ended March 31, 2001. </FN> </TABLE> See notes to consolidated condensed financial statements. Page 4
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands) (Unaudited) <TABLE> Three Months Ended March 31, 2002 2001 <S> <C> <C> Net Income ............................................................ $ 5,479 $ 5,106 ------- ------- Other comprehensive income, net of tax: Unrealized (losses) gains on securities available for sale: Unrealized holding (losses) gains arising during the period, net of income tax benefit (expense) of $815 and $(1,187).............. (1,223) 1,781 Less: Reclassification adjustment for gains included in net income, net of income tax expense of $(46) and $0......... 72 ------- ------- (1,295) 1,781 ------- ------- Comprehensive income .................................................. $ 4,184 $ 6,887 ======= ======= </TABLE> See notes to consolidated condensed financial statements Page 5
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands) (Unaudited) <TABLE> 2002 2001 --------- --------- <S> <C> <C> Balances, January 1 ............................................ $ 179,128 $ 156,063 Net income ..................................................... 5,479 5,106 Cash dividends ................................................. (2,939) (2,665) Other comprehensive income (loss), net of tax................... (1,295) 1,781 Stock issued under dividend reinvestment and stock purchase plan 234 210 Stock options exercised ........................................ 87 20 Stock Redeemed ................................................. (54) (1,415) Issuance of stock in acquisition ............................... 2,444 --------- --------- Balances, March 31 ............................................. $ 183,084 $ 159,100 ========= ========= </TABLE> See notes to consolidated condensed financial statements Page 6
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited) <TABLE> Three Months Ended March 31, ------------------------------------ 2002 2001 ---------------- ---------------- <S> <C> <C> Cash Flows From Operating Activities: Net income........................................................................ $ 5,479 $ 5,106 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses....................................................... 1,192 653 Depreciation and amortization................................................... 775 1,207 Securities amortization, net................................................... 64 (79) Securities gains, net........................................................... (113) Gain on sale of premises and equipment.......................................... (3) Mortgage loans originated for sale.............................................. (4,988) (5,206) Proceeds from sales of mortgage loans........................................... 5,132 4,746 Change in interest receivable................................................... 668 1,183 Change in interest payable...................................................... 133 233 Other adjustments............................................................... (78) (712) ---------------- ---------------- Net cash provided by operating activities..................................... $ 8,261 $ 7,131 ---------------- ---------------- Cash Flows From Investing Activities: Net change in interest-bearing deposits........................................... 53 (749) Purchases of Securities available for sale................................................... (21,630) (4,169) Proceeds from maturities of Securities available for sale................................................... 34,110 33,279 Securities held to maturity..................................................... 1,527 2,244 Proceeds from sales of Securities available for sale................................................... 5,547 Securities held to maturity..................................................... Net change in loans............................................................... (5,670) (11,232) Net cash received in acquisition.................................................. 1,228 Purchases of premises and equipment............................................... (1,522) (324) Proceeds from sale of fixed assets................................................ 8 ---------------- ---------------- Net cash provided by investing activities....................................... 13,651 19,049 ---------------- ---------------- </TABLE> (continued) Page 7
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited) <TABLE> Three Months Ended March 31 ------------------------------------ 2002 2001 ---------------- ---------------- <S> <C> <C> Cash Flows From Financing Activities: Net change in Demand and savings deposits........................................... $ (26,069) $ (26,929) Certificates of deposit and other time deposits....................... (21,496) (30,553) Borrowings............................................................ (9,450) (8,717) Cash dividends.......................................................... (2,939) (2,665) Stock issued under dividend reinvestment and stock purchase plan........ 234 210 Stock options exercised................................................. 87 20 Stock repurchased....................................................... (54) (1,415) ---------------- ---------------- Net cash used by financing activities................................. (59,687) (70,049) ---------------- ---------------- Net Change in Cash and Cash Equivalents................................... (37,775) (43,869) Cash and Cash Equivalents, January 1...................................... 103,028 67,463 ---------------- ---------------- Cash and Cash Equivalents, March 31....................................... $ 65,253 $ 23,594 ================ ================ </TABLE> See notes to consolidated condensed financial statements. Page 8
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 1. General The significant accounting policies followed by First Merchants Corporation ("Corporation") and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting, except for the change in method of accounting or adoption of accounting pronouncements discussed more fully in Note 2. All adjustments which are of a normal recurring nature and are in the opinion of management necessary for a fair statement of the results for the periods reported have been included in the accompanying consolidated condensed financial statements. The consolidated condensed balance sheet of the Corporation as of December 31, 2001 has been derived from the audited consolidated balance sheet of the Corporation as of that date. Certain information and note disclosures normally included in the Corporation's annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation's Form 10-K annual report filed with the Securities and Exchange Commission. The results of operations for the period are not necessarily indicative of the results to be expected for the year. NOTE 2. Accounting Matters ACCOUNTING FOR A BUSINESS COMBINATION Statement of Financial Accounting Standards ("SFAS") No. 141 requires that all business combinations should be accounted for using the purchase method of accounting; use of the pooling method is prohibited. This Statement requires that goodwill be initially recognized as an asset in the financial statement and measured as the excess of the cost of an acquired entity over the net of the amounts assigned to identifiable assets acquired and liabilities assumed. In addition, SFAS No. 141 requires all other intangibles, such as core deposit intangibles for a financial institution, to be identified. The provisions of Statement No. 141 were effective for any business combination that was initiated after June 30, 2001. ACCOUNTING FOR GOODWILL Under the provisions of SFAS No. 142, goodwill should not be amortized but should be tested for impairment at the reporting unit level. Impairment test of goodwill should be done on an annual basis unless events or circumstances indicate impairment has occurred in the interim period. The annual impairment test can be performed at any time during the year as long as the measurement date is used consistently from year to year. Impairment testing is a two step process, as outlined within the statement. If the fair value of goodwill is less than its carrying value, then the goodwill is deemed impaired and a loss recognized. Any impairment loss recognized as a result of completing the transitional impairment test should be treated as a change in accounting principle and recognized in the first interim period financial statements. The Corporation adopted these new accounting rules on January 1, 2002. As a result, the Corporation will not amortize the goodwill it has recorded, but will make an annual assessment of any impairment in goodwill and, if necessary, recognize an impairment loss at that time. The Corporation had goodwill of $27,681,000 at March 31, 2002 and identified no impairment loss. Page 9
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 3. Business Combinations On April 1, 2002, the Corporation completed the acquisition of Lafayette Bancorporation and its wholly owned subsidiary, Lafayette Bank and Trust Company, Lafayette, Indiana (collectively "Lafayette"). The acquisition will be accounted for under the purchase method of accounting. The total purchase price paid was approximately $115,978,000. Under the terms of the agreement, the Corporation will issue approximately 2,773,059 shares of its common stock, at a value of $23.48 (as determined by the average of the closing price of the stock for the two days prior, the day of and the two days after the acquisition was announced) and approximately $50,867,000 cash in exchange for all the common stock of Lafayette. The Corporation anticipates amortizing core deposit intangibles over ten years utilizing a 150% declining balance method. At December 31, 2001, Lafayette had total assets and shareholders' equity of $762,318,000 and $59,120,000. The results of operations of Lafayette will be included in the Corporation's results beginning April 1, 2002. Effective January 1, 2002, the Corporation acquired Delaware County Abstract Company, Inc. ("DCA") and Beebe & Smith Title Insurance Company, Inc. ("B & S"), which were merged into Indiana Title Insurance Company, a wholly-owned subsidiary of the Corporation. The title insurance operations were subsequently contributed to Indiana Title Insurance Company, LLC in which the Corporation has a 52.12% ownership interest. This acquisition was deemed to be an immaterial acquisition. Page 10
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) <TABLE> NOTE 4. Investment Securities Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value <S> <C> <C> <C> <C> Available for sale at March 31, 2002 U.S. Treasury .................... $ 124 $ 124 Federal agencies.................. 33,633 $ 473 $ 138 33,968 State and municipal .............. 81,972 1,441 538 82,875 Mortgage-backed securities ....... 80,541 881 54 81,368 Other asset-backed securities..... 5,881 65 9 5,937 Corporate obligations............. 3,496 76 3,572 Marketable equity securities...... 5,507 123 5,384 -------- -------- -------- -------- Total available for sale ..... 211,154 2,936 862 213,228 -------- -------- -------- -------- Held to maturity at March 31, 2002 State and municipal............... 6,931 186 58 7,059 Mortgage-backed securities........ 202 202 -------- -------- -------- -------- Total held to maturity ....... 7,133 186 58 7,261 -------- -------- -------- -------- Total investment securities .. $218,287 $ 3,122 $ 920 $220,489 ======== ======== ======== ======== </TABLE> Page 11
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) <TABLE> Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value <S> <C> <C> <C> <C> Available for sale at December 31, 2001 U.S. Treasury ...................... $ 124 $ 124 Federal agencies ................... 30,808 $ 767 $ 2 31,573 State and municipal ................ 74,776 1,644 215 76,205 Mortgage-backed securities ......... 100,811 1,710 1 102,520 Other asset-backed securities ...... 10,116 167 10,283 Corporate obligations .............. 3,498 116 3,614 Marketable equity securities ....... 7,472 123 7,349 -------- -------- -------- -------- Total available for sale ........ 227,605 4,404 341 231,668 -------- -------- -------- -------- Held to maturity at December 31, 2001 State and municipal ................ 8,426 166 58 8,534 Mortgage-backed securities ......... 228 228 -------- -------- -------- -------- Total held to maturity .......... 8,654 166 58 8,762 -------- -------- -------- -------- Total investment securities ..... $236,259 $ 4,570 $ 399 $240,430 ======== ======== ======== ======== </TABLE> Page 12
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 5. Loans and Allowance <TABLE> March 31, December 31, 2002 2001 ---- ---- <S> <C> <C> Loans: Commercial and industrial loans .............................................. $ 307,450 $ 301,962 Agricultural production financing and other loans to farmers ................. 29,465 29,645 Real estate loans: Construction ............................................................... 51,096 58,316 Commercial and farmland .................................................... 255,232 230,233 Residential ................................................................ 526,955 544,028 Individuals' loans for household and other personal expenditures ............. 173,300 179,325 Tax-exempt loans ............................................................. 6,983 7,277 Other loans .................................................................. 13,570 8,800 ----------- ----------- 1,364,051 1,359,586 Allowance for loan losses..................................................... (15,128) (15,141) ----------- ----------- Total Loans............................................................... $ 1,348,923 $ 1,344,445 =========== =========== Three Months Ended March 31 2002 2001 ----------- ----------- Allowance for loan losses: Balances, January 1 .......................................................... $ 15,141 $ 12,454 Provision for losses ......................................................... 1,192 653 Recoveries on loans .......................................................... 381 125 Loans charged off ............................................................ (1,586) (505) ----------- ----------- Balances, March 31 ........................................................... $ 15,128 $ 12,727 =========== =========== </TABLE> NOTE 6. Net Income Per Share <TABLE> Three Months Ended March 31, 2002 2001 ------------------------------------------- ------------------------------------------- Weighted- Weighted- Average Per Share Average Per Share Income Shares Amount Income Shares Amount ------ ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> <C> Basic net income per share: Net income available to common stockholders................. $ 5,479 12,778,366 $ .43 $ 5,106 12,178,006 $ .42 ========== ========== Effect of dilutive stock options........ 109,132 84,044 ---------- ------------ ---------- ------------ Diluted net income per share: Net income available to common stockholders and assumed conversions............. 5,479 12,887,498 $ .43 5,106 12,262,050 $ .42 ========== ============ ========== ========== ============ ========== Options to purchase 76,909 and 112,413 shares at March 31, 2002 and 2001 were not included in the earnings per share calculation because the exercise price exceeded the average market price. </TABLE> Page 13
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) Note 7. Cumulative Trust Preferred Securities On April 12, 2002, the Corporation and First Merchants Capital Trust I (the "Trust") entered into an Underwriting Agreement with Stifel, Nicolaus & Company, Incorporated and RBC Dain Rauscher Inc. for themselves and as co-representatives for several other underwriters, (the "Underwriting Agreement"). On April 17, 2002 and pursuant to the Underwriting Agreement, the Trust issued 1,850,000 8.75% Cumulative Trust Preferred Securities (liquidation amount $25 per Preferred Security) (the "Preferred Securities") with an aggregate liquidation value of $46,250,000. On April 23, 2002 and pursuant to the Underwriting Agreement, the Trust issued an additional 277,500 Preferred Securities with an aggregate liquidation value of $6,937,500 to cover over-allotments. The proceeds from the sale of the Preferred Securities were invested by the Trust in the Corporation's 8.75% Junior Subordinated Debentures due June 30, 2032 (the "Debentures"). The proceeds from the issuance of the Debentures were used by the Corporation to fund a portion of the cash consideration payable to the shareholders of Lafayette Bancorporation in connection with the acquisition referenced in Note 3. The Preferred Securities will be recorded as borrowings in the Corporation's consolidated balance sheet. Page 14
FIRST MERCHANTS CORPORATION FORM 10-Q Item 2. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations - -------------- Forward-Looking Statements The Corporation from time to time includes forward-looking statements in its oral and written communication. The Corporation may include forward-looking statements in filings with the Securities and Exchange Commission, such as this Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. The Corporation intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and the Corporation is including this statement for purposes of these safe harbor provisions. Forward-looking statements can often be identified by the use of words like "estimate," "project," "intend," "anticipate," "expect" and similar expressions. These forward-looking statements include: * statements of the Corporation's goals, intentions and expectations; * statements regarding the Corporation's business plan and growth strategies; * statements regarding the asset quality of the Corporation's loan and investment portfolios; and * estimates of the Corporation's risks and future costs and benefits. These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors which could affect the actual outcome of future events: * fluctuations in market rates of interest and loan and deposit pricing, which could negatively affect the Corporation's net interest margin, asset valuations and expense expectations; * adverse changes in the Indiana economy, which might affect the Corporation's business prospects and could cause credit-related losses and expenses; * adverse developments in the Corporation's loan and investment portfolios; * competitive factors in the banking industry, such as the trend towards consolidation in the Corporation's market; and * changes in the banking legislation or the regulatory requirements of federal and state agencies applicable to bank holding companies and banks like the Corporation's affiliate banks. Because of these and other uncertainties, the Corporation's actual future results may be materially different from the results indicated by these forward- looking statements. In addition, the Corporation's past results of operations do not necessarily indicate its future results. Results of Operations Net income for the three months ended March 31, 2002, was $5,479,000, compared to $5,106,000 earned in the same period of 2001. Diluted earnings per share were $.43 compared to the $.42 reported for the first quarter 2001. Cash basis earnings per share were $.43 down $.01 from $.44 in 2001. Annualized returns on average assets and average shareholder's equity for quarter ended March 31, 2002 were 1.25 percent and 12.14 percent, respectively, compared with 1.28 percent and 13.03 percent for the same period of 2001. Page 15
FIRST MERCHANTS CORPORATION FORM 10-Q Capital The Corporation's capital continues to exceed regulatory minimums and management believes that its capital levels continue to be a distinct advantage in the competitive environment in which the Corporation operates. The Corporation's Tier I capital to average assets ratio was 8.7 percent at year-end 2001 and 8.6 percent at March 31, 2002. At March 31, 2002, the Corporation had a Tier I risk-based capital ratio of 11.4 percent and total risk-based capital ratio of 12.5 percent. Regulatory capital guidelines require a Tier I risk-based capital ratio of 4.0 percent and a total risk-based capital ratio of 8.0 percent. Banks with Tier I risk-based capital ratios of 6.0 percent and total risk-based capital ratios of 10.0 percent are considered "well capitalized." Asset Quality/Provision for Loan Losses Asset quality has been a major factor in the Corporation's ability to generate consistent profit improvement. The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount provided for loan losses and the determination of the adequacy of the allowance are based on a continuous review of the loan portfolio, including an internally administered loan "watch" list and an independent loan review provided by an outside accounting firm. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that cannot be specifically identified. The following table summarizes the non-accrual, contractually past due 90 days or more other than non-accruing and restructured loans for the Corporation. <TABLE> - -------------------------------------------------------------------------------- (Dollars in Thousands) March 31, December 31, 2002 2001 - -------------------------------------------------------------------------------- <S> <C> <C> Non-accrual loans .................. $ 8,043 $ 6,327 Loans contractually past due 90 days Or more other than nonaccruing 4,292 4,828 Restructured loans ................. 1,900 3,511 ------- ------- Total ................ $14,235 $14,666 ======= ======= - -------------------------------------------------------------------------------- </TABLE> At March 31, 2002, non-performing loans totaled $14,235,000, a decrease of $431,000 from December 31, 2001. At March 31, 2002, impaired loans totaled $21,477,000. In addition, an allowance for losses was not deemed necessary for impaired loans totaling $11,538,000, but an allowance of $2,855,000 was recorded for the remaining balance of impaired loans of $9,939,000 and is included in the Corporation's allowance for loan losses. The average balance of impaired loans for the first quarter ended March 31, 2002 was $21,172,000. At December 31, 2001, impaired loans totaled $21,161,000. In addition, an allowance for losses was not deemed necessary for impaired loans totaling $10,780,000, but an allowance of $3,251,000 was recorded for the remaining balance of impaired loans of $10,381,000 and is included in the Corporation's allowance for loan losses. The average balance of impaired loans for 2001 was $22,327,000. At March 31, 2002, the allowance for loan losses decreased by $13,000, to $15,128,000, down slightly from year end 2001. As a percent of loans, the allowance was 1.11 percent, up from 1.07 percent at year end 2001. Page 16
FIRST MERCHANTS CORPORATION FORM 10-Q The first quarter 2002 provision of $1,192,000 was up $539,000 from $653,000 for the same quarter in 2001. Net charge offs amounted to $1,205,000 during the quarter, an increase of $825,000 from $380,000 for the same quarter in 2001. The increase in net charge offs was primarily due to two commercial loans charged off during the first quarter of 2002, totaling approximately $700,000, that had been reserved for and included in the Corporation's allowance for loan losses at December 31, 2001. The increased provision has helped improve the allowance to total loans by 4 basis points over the first quarter of 2001, increasing the total to 1.11% at March 31, 2002. <TABLE> Three Months Ended March 31, ------------------ ------------------ 2002 2001 ---- ---- (Dollars in Thousands) <S> <C> <C> Balance at beginning of period ......................... $15,141 $12,454 ------- ------- Chargeoffs ............................................. 1,586 518 Recoveries ............................................. 381 138 ------- ------- Net chargeoffs ......................................... 1,205 380 Provision for loan losses .............................. 1,192 653 ------- ------- Balance at end of period ............................... $15,128 $12,727 ======= ======= Ratio of net chargeoffs during the period to average loans outstanding during the period (1)....................... .35 .03 (1) First three months annualized </TABLE> Liquidity, Interest Sensitivity, and Disclosures About Market Risk Asset/Liability Management has been an important factor in the Corporation's ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor the Corporation's liquidity and interest sensitivity positions at regular meetings to review how changes in interest rates may affect earnings. Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, the Corporation's exposure to changes in net interest income given various rate scenarios and the economic and competitive environments. It is the objective of the Corporation to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal of the Corporation's Asset/Liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are both constructed, presented, and monitored quarterly. Management believes that the Corporation's liquidity and interest sensitivity position at March 31, 2002, remained adequate to meet the Corporation's primary goal of achieving optimum interest margins while avoiding undue interest rate risk. Page 17
FIRST MERCHANTS CORPORATION FORM 10-Q The Corporation places its greatest credence in net interest income simulation modeling. The GAP/Interest Rate Sensitivity Report is believed by the Corporation's management to have two major shortfalls. The GAP/Interest Rate Sensitivity Report fails to precisely gauge how often an interest rate sensitive product reprices, nor is it able to measure the magnitude of potential future rate movements. Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. The Corporation's asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a 12-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent management's view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into the earnings of the Corporation. The base scenario is highly dependent on numerous assumptions embedded in the model, including assumptions related to future interest rates. While the base sensitivity analysis incorporates management's best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For mortgage-related assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity products, e.g., savings, money market, NOW and demand deposits reflect management's best estimate of expected future behavior. The comparative rising and falling scenarios for the period ended March 31, 2003 assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case senario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation for the period ended March 31, 2003 are as follows: Driver Rates RISING FALLING ================================================================================ Prime 200 Basis Points (150)Basis Points Federal Funds 200 (100) One-Year T-Bill 200 (100) Two-Year T-Bill 200 (100) Interest Checking 100 (25) MMIA Savings 75 (25) Money Market Index 200 (100) CD's 170 (130) FHLB Advances 200 (100) Results for the base, rising and falling interest rate scenarios are listed below, based upon the Corporation's rate sensitive assets at March 31, 2002. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. BASE RISING FALLING ================================================================================ Net Interest Income (dollars in thousands) $ 71,938 $ 77,052 $ 69,054 Variance from base $ 5,114 $ (2,884) Percent of change from base 7.11% (4.01)% Page 18
FIRST MERCHANTS CORPORATION FORM 10-Q The comparative rising and falling scenarios for the year ended December 31, 2002 assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case senario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation for the year ended December 31, 2002 are as follows: Driver Rates RISING FALLING ================================================================================ Prime 200 Basis Points (150)Basis Points Federal Funds 200 (100) One-Year T-Bill 200 (100) Two-Year T-Bill 200 (100) Interest Checking 100 (25) MMIA Savings 75 (25) Money Market Index 200 (100) CD's 170 (130) FHLB Advances 200 (100) Results for the base, rising and falling interest rate scenarios are listed below, based upon the Corporation's rate sensitive assets at December 31, 2001. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. BASE RISING FALLING ================================================================================ Net Interest Income (dollars in thousands) $ 74,029 $ 74,356 $ 71,540 Variance from base $ 327 $ (2,489) Percent of change from base .44% (3.36)% Page 19
FIRST MERCHANTS CORPORATION FORM 10-Q Earning Assets The following table presents the earning asset mix as of March 31, 2002, and December 31, 2001. Loans grew by over $4.3 million from December 31, 2001, to March 31, 2002, while investment securities declined by $20.1 million during the same period. Commercial and industrial and other loans increased by more than $10 million, while individuals' loans for household and personal expenditures declined by nearly $6 million. <TABLE> - --------------------------------------------------------------------------------------------------- EARNING ASSETS (Dollars in Millions) March 31, December 31, 2002 2001 - --------------------------------------------------------------------------------------------------- <S> <C> <C> Federal funds sold and interest-bearing deposits $ 25.0 $ 38.2 Securities available for sale .................. 213.2 231.7 Securities held to maturity .................... 7.1 8.7 Loans .......................................... 1,364.2 1,359.9 Federal Reserve and Federal Home Loan Bank stock 8.4 8.4 ---------- ---------- Total ..................... $ 1,617.9 $ 1,646.9 ========== ========== - --------------------------------------------------------------------------------------------------- </TABLE> Deposits and Borrowings The following table presents the level of deposits and borrowed funds (Federal funds purchased, repurchase agreements, U.S. Treasury demand notes, Federal Home Loan Bank advances and other borrowed funds)at December 31, 2001 and March 31, 2002. - -------------------------------------------------------------------------------- <TABLE> (Dollars in Millions) March 31, December 31, 2002 2001 ---------- ------------ <S> <C> <C> Deposits ........................................ $ 1,373.7 $ 1,421.3 Securities sold under repurchase agreements...... 43.1 45.6 Other short-term borrowings ..................... 4.5 16.8 Federal Home Loan Bank advances ................. 108.9 103.5 Other borrowed funds ............................ 8.5 8.5 </TABLE> The Corporation has continued to leverage its capital position with Federal Home Loan Bank advances, as well as, repurchase agreements which are pledged against acquired investment securities as collateral for the borrowings. The interest rate risk is included as part of the Corporation's interest simulation discussed in Management's Discussion and Analysis under the heading Liquidity, Interest Sensitivity, and Disclosures about Market Risk. Page 20
FIRST MERCHANTS CORPORATION FORM 10-Q Net Interest Income Net Interest Income is the primary source of the Corporation's earnings. It is a function of net interest margin and the level of average earning assets. The table below presents the Corporation's asset yields, interest expense, and net interest income as a percent of average earning assets for the three months ended March 31, 2002 and 2001. Annualized net interest income (FTE) for the three months ended March 31, 2002 increased by $11,697,000, or 19.1 percent over the same period in 2001, due to an increase in average earning assets of over $144 million. For the same period interest income and interest expense, as a percent of average earning assets, decreased 134 basis points, 163 basis points respectively. <TABLE> - --------------------------- ------------------- -------------------- -------------------- -------------- --------------------- (Dollars in Thousands) Interest Income Net Interest Income Annualized (FTE) as a Percent Interest Expense (FTE) as a Percent Net Interest Income of Average as a Percent of Average Average On a Earning Assets of Average Earning Assets Earning Fully Taxable Earning Assets Assets Equivalent Basis - --------------------------- ------------------- -------------------- -------------------- -------------- --------------------- For the three months Ended March 31, <S> <C> <C> <C> <C> <C> 2002 6.89% 2.50% 4.39% $1,635,783 $72,870 2001 8.23% 4.13% 4.10% $1,491,338 $61,173 Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. - ------------------------------------------------------------------------------------------------------------------------------ </TABLE> Page 21
FIRST MERCHANTS CORPORATION FORM 10-Q Other Income The Corporation has placed emphasis on the growth of non-interest income in recent years by offering a wide range of fee-based services. Fee schedules are regularly reviewed by a pricing committee to ensure that the products and services offered by the Corporation are priced to be competitive and profitable. Other income in the first quarter of 2002 exceeded the same quarter in the prior year by $770,000, or 17.5 percent. Three major areas account for most of the increase: 1. Service charges on deposit accounts increased $191,000 or 15.1 percent due to increased number of accounts and price adjustments. 2. Net realized gains on sales of available-for-sale securities totaled $118,000 in the first quarter of 2002. No sales occurred during the same quarter in the prior year. 3. Gains on sale of mortgage loans included in other income increased by $107,000, or 60.1 percent, due to increased mortgage volume. In addition, continued low mortgage loan interest rates caused an increase in refinancing volume during January and February of the current quarter, which facilitated an increase in loan sales activity. Other Expenses Total other expenses represent non-interest operating expenses of the Corporation. First quarter other expense in 2002 exceeded the same quarter of the prior year by $2,527,000, or 24.1 percent. Three major areas account for most of the increase: 1. Salaries and benefit expense grew $1,409,000 or 24.0 percent, due to normal salary increases, staff additions and additional salary cost related to the acquisition of Frances Slocum Bank and Trust Company. 2. Data processing fees increased by $283,000, or 53.8 percent, primarily due to increases in processing expenses related to greater usage of debit/ATM cards by customers and increases in loans originated and processed during the quarter. 3. Telephone expenses increased by $322,000 or 121.5%, primarily due to additional telephone costs related to the acquisition of Frances Slocum Bank and Trust Company and increased service contract charges related to greater usage of telephone lines. Page 22
FIRST MERCHANTS CORPORATION FORM 10-Q Income Taxes Income tax expense, for the three months ended March 31, 2002, increased by $20,000 over the same period in 2001. The effective tax rate was 34.4 and 35.8 percent for the 2002 and 2001 periods. Other The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including the Corporation, and that address is (http://www.sec.gov). Item 3. Quantitative and Qualitative Disclosures About Market Risk - ------------------------------------------------------------------- The information required under this item is included as part of Management's Discussion and Analysis of Financial Condition and Results of Operations, under the heading Liquidity, Interest Sensitivity, and Disclosures About Market Risk. Page 23
FIRST MERCHANTS CORPORATION FORM 10-Q PART II. OTHER INFORMATION Item 1. Legal Proceedings - -------------------------- None Item 2. Changes in Securities and Use of Proceeds - -------------------------------------------------- a. None b. None c. On January 1, 2002, the Corporation issued a total of 103,732 unregistered shares of its common stock pursuant to Agreements of Merger dated December 28, 2001, between the Corporation and DCA and the Corporation and B & S, as previously discussed in Note 3. The Corporation issued the unregistered shares to the sole shareholder of DCA and sole shareholder of B & S, at a value of $23.50 per share, in exchange for all the common stock of both DCA and B & S. The issuance by the Corporation of its shares of common stock were not registered under the Securities Act of 1933, as amended ("Securities Act"). The shares were issued pursuant to the exemption contemplated in Section 4(2) of the Securities Act, for transactions not involving a public offering. d. None Item 3. Defaults Upon Senior Securities - ---------------------------------------- None Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ At the March 18th, 2002, Special Meeting of Shareholders of the Corporation, the following matter was submitted to a vote of the shareholders. Approval of the Agreement of Reorganization and Merger between the Corporation and Lafayette Bancorporation. Vote Count ---------- Shares For............. 9,305,260.9553 Shares Against......... 94,614.3984 Shares Abstain......... 32,420.0291 Item 5. Other Information - -------------------------- None Item 6. Exhibits and Reports on Form 8-K - ----------------------------------------- a. Exhibits None b. Reports on Form 8-K None Page 24
FIRST MERCHANTS CORPORATION FORM 10-Q 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. First Merchants Corporation --------------------------- (Registrant) Date May 15, 2002 by /s/ Michael L. Cox --------------------------- ------------------------------------- Michael L. Cox President and Chief Executive Officer Date May 15, 2002 by /s/ Mark K. Hardwick --------------------------- ------------------------------------- Mark K. Hardwick Senior Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer) Page 25