Mercantile Bank - 10-Q quarterly report FY

310 Leonard Street, NW, Grand Rapids, MI 49504
(Address of principal executive offices) (Zip Code)

(616) 406-3000
(Registrant’s telephone number, including area code)

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.

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

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

At November 8, 2007, there were 8,480,604 shares of Common Stock outstanding.

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This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “intends”, “is likely”, “plans”, “projects”, and variations of such words and similar expressions, are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward looking-statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

Future Factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economies; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2006. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, Mercantile Bank of Michigan (“our bank”), our bank’s three subsidiaries Mercantile Bank Mortgage Company, LLC (“our mortgage company”), Mercantile Bank Real Estate Co., LLC (“our real estate company”) and Mercantile Insurance Center, Inc. (“our insurance center”), at September 30, 2007 to December 31, 2006 and the results of operations for the three and nine months ended September 30, 2007 and September 30, 2006. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to “us,” “we,” “our,” or “the company” include Mercantile Bank Corporation and its consolidated subsidiaries referred to above.

Generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting and disclosure matters. Management must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a complete discussion of our significant accounting policies, see footnotes to our Consolidated Financial Statements included on pages F-35 through F-40 in our Form 10-K for the fiscal year ended December 31, 2006 (Commission file number 000-26719). Below is a discussion of our allowance for loan and lease losses policy. This policy is critical because it is highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. Management has reviewed the application of this policy with the Audit Committee of the company’s Board of Directors.

Allowance for Loan and Lease Losses: The allowance for loan and lease losses (“allowance”) is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and recoveries, and decreased by charge-offs. Management estimates the allowance balance required based on past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is likely.

A loan or lease is impaired when full payment under the loan or lease terms is not expected. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan or lease is impaired, a portion of the allowance is allocated so that the loan or lease is reported, net, at the present value of estimated future cash flows using the loan’s or lease’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans and leases are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship.

During the first nine months of 2007, our assets increased from $2,067.3 million on December 31, 2006, to $2,106.4 million on September 30, 2007. This represents an increase in total assets of $39.1 million, or 1.9%. The asset growth was comprised primarily of a $48.0 million increase in net loans, a $5.2 million increase in securities and a $1.8 million increase in other real estate owned and repossessed assets, partially offset by a $22.1 million decline in cash and cash equivalents. The growth in total assets was primarily funded by a $40.0 million increase in Federal Home Loan Bank advances, partially offset by a $5.9 million decrease in deposits and a $6.5 million decrease in federal funds purchased.

Commercial loans and leases increased by $61.2 million during the first nine months of 2007, and at September 30, 2007, totaled $1,666.6 million, or 92.7% of the total loan and lease portfolio. The growth in our commercial loan and lease portfolio has slowed over the past several quarters, primarily reflecting the competitive pricing and underwriting environments within our markets. These competitive pressures, from financial institutions and other entities such as private equity funds, have negatively impacted the volume of loans we have booked and accelerated the level of loan payoffs. Despite these competitive pressures, we remain committed to our traditionally high standards of underwriting and believe the long term benefits of this posture outweigh the likely short term negative impact to our net interest income and net income.

The continued significant concentration of the loan and lease portfolio in commercial loans and leases and the typical rapid growth of this portion of our lending business is consistent with our stated strategy of focusing a substantial amount of efforts on “wholesale” banking. Corporate and business lending continues to be an area of expertise of our senior management team, and our commercial lenders have extensive commercial lending experience, with most having at least 10 years’ experience. Of each of the loan categories that we originate, commercial loans and leases are most efficiently originated and managed; thus limiting overhead costs by necessitating the attention of fewer employees. Our commercial lending business generates the largest portion of local deposits, and is our primary source of demand deposits.

Residential mortgage loans and consumer loans decreased an aggregate $9.7 million during the first nine months of 2007. As of September 30, 2007, residential mortgage and consumer loans totaled a combined $130.4 million, or 7.3% of the total loan and lease portfolio. Although we plan to increase our non-commercial loan portfolios in future periods, we expect the commercial sector of our lending efforts and resultant assets to remain the dominant loan portfolio category given our wholesale banking strategy.

Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans and leases to provide effective loan portfolio administration. The credit policies and procedures are meant to limit the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and leases and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans and leases, which exhibit characteristics (financial or otherwise) that could cause the loans and leases to become nonperforming or require restructuring in the future, are included on the internal “watch list”. Senior management reviews this list regularly.

Net loan and lease charge-offs during the first nine months of 2007 totaled $2.7 million, or 0.21% of average total loans and leases on an annualized basis. During the first nine months of 2006, net loan and lease charge-offs also totaled $2.7 million, or 0.22% of average total loans and leases on an annualized basis. Nonperforming assets, including $2.8 million of foreclosed real estate and repossessed assets, totaled $25.9 million, or 1.23% of total assets, as of September 30, 2007. At December 31, 2006, nonperforming assets totaled $9.6 million, including $1.0 million of foreclosed real estate and repossessed assets, or 0.46% of total assets. The majority of the increase in nonperforming assets can be attributed to four commercial loan relationships totaling $12.0 million that were placed into non-accrual status during the second and third quarters of 2007. Over 80 percent of nonperforming loans are real estate-related, and the majority is associated with residential real estate development. The decline in real estate prices and slowdown in sales has stretched the cash flow of our local developers and eroded the value of our underlying collateral.

We continuously strive to improve our loan and lease underwriting and administration processes. We believe we have instilled a strong credit culture within our lending departments, which in part is reflected in our historically low loan and lease net charge-off and delinquency ratios. Over 98% of the loan portfolio consists of loans extended directly to companies and individuals doing business and residing within our market areas. The remaining portion is comprised of commercial loans participated with certain unaffiliated commercial banks outside of our market areas, which are underwitten using the same loan underwriting criteria as though we were the originating bank.

Securities increased $5.2 million during the first nine months of 2007, totaling $207.6 million as of September 30, 2007. Purchases during the first nine months of 2007 totaled $14.2 million, while proceeds from the maturities, calls and repayments of securities totaled $9.0 million. Our securities portfolio primarily consists of U.S. Government Agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government Agencies, investment-grade tax-exempt municipal securities and Federal Home Loan Bank of Indianapolis (“FHLBI”) stock.

Cash and cash equivalents decreased $22.1 million during the first nine months of 2007, totaling $29.3 million on September 30, 2007. Cash and due from bank balances were down $22.3 million, while short-term investments increased $0.2 million. Although our cash balances were relatively unchanged, there were two primary factors resulting in a relatively large decline in our due from bank balances: in early July, we initiated an image exchange program for our outgoing cash letter with our primary correspondent bank that resulted in faster collection, and in mid-September we instituted a deposit reclassification program, which impacts our reserve requirement calculation, that virtually eliminated our need to maintain balances with the Federal Reserve Bank of Chicago. The initiation of these two programs during the third quarter provided for a combined reduction in due from bank balances of approximately $13.0 million. The remainder of the decline in due from bank balances primarily results from the typical relatively large day-to-day fluctuations of our outgoing cash letter reflecting our commercial lending and wholesale funding focus. We did not have federal funds sold on either September 30, 2007 or December 31, 2006; however, our average federal funds sold position during the first nine months of 2007 equaled $8.8 million.

Premises and equipment at September 30, 2007 equaled $34.5 million, a net increase of $1.0 million over the past nine months. Purchases of premises and equipment during the first nine months of 2007 totaled $3.0 million, primarily reflecting a portion of the construction costs associated with our new banking facility located in East Lansing, Michigan, which opened in May 2007. Depreciation expense during the first nine months of 2007 equaled $2.0 million.

Deposits decreased $5.9 million during the first nine months of 2007, totaling $1,641.0 million at September 30, 2007. Local deposits increased $15.5 million, while out-of-area deposits decreased $21.4 million. As a percent of total deposits, local deposits equaled 39.5% on September 30, 2007, an increase over the 38.4% as of December 31, 2006. Noninterest-bearing demand deposits, comprising 7.4% of total deposits, decreased $11.9 million during the first nine months of 2007. Savings deposits (4.8% of total deposits) decreased $13.7 million, interest-bearing checking deposits (2.6% of total deposits) increased $2.2 million and money market deposit accounts (0.7% of total deposits) increased $2.5 million during the first nine months of 2007. Local certificates of deposit, comprising 24.0% of total deposits, increased by $36.4 million during the first nine months of 2007. The increase in local certificates of deposit is primarily attributable to increases in balances from municipalities and transfers of monies by consumer and commercial customers from savings accounts to certificates of deposit products, the latter of which primarily reflecting that rates offered on certificates of deposit products are higher than the rates offered on savings accounts.

Out-of-area deposits decreased $21.4 million during the first nine months of 2007, totaling $992.4 million as of September 30, 2007. Out-of-area deposits consist primarily of certificates of deposit obtained from depositors located outside our market areas and placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. The owners of out-of-area deposits include individuals, businesses and municipal governmental units located throughout the United States.

Securities sold under agreements to repurchase (“repurchase agreements”) increased $3.2 million during the first nine months of 2007, totaling $88.7 million as of September 30, 2007. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested into over-night interest-bearing repurchase agreements. Although not considered a deposit account and therefore not afforded federal deposit insurance, the repurchase agreements have characteristics very similar to that of our business checking deposit accounts.

Federal funds purchased declined by $6.5 million during the first nine months of 2007, equaling $3.3 million as of September 30, 2007. Advances obtained from the FHLBI totaled $135.0 million as of September 30, 2007, an increase of $40.0 million from the $95.0 million outstanding on December 31, 2006. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans and first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of September 30, 2007 totaled $326.4 million, with availability approximating $180.0 million.

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet deposit withdrawals, fund loans and operate our company. Liquidity is primarily achieved through the growth of local and out-of-area deposits, advances from the FHLBI and federal funds purchased, as well as liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

Our liquidity strategy is to fund loan growth with deposits, repurchase agreements and FHLBI advances, and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity. Although deposit and repurchase agreement growth from customers located in our market areas has generally consistently increased, this growth has not been sufficient to meet our historical substantial loan growth and provide monies for additional investing activities. To assist in providing the additional needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, primarily comprised of certificates of deposit from customers outside of our market areas and advances from the FHLBI, totaled $1,127.4 million, or 60.5% of combined deposits and borrowed funds as of September 30, 2007. As of December 31, 2006, wholesale funds totaled $1,108.8 million, or 60.7% of combined deposits and borrowed funds.

Although local deposits have and are expected to increase as new business, governmental and individual deposit relationships are established and as existing customers increase balances in their accounts, the relatively high reliance on wholesale funds will likely remain. As part of our interest rate risk management strategy, a majority of our wholesale funds are comprised of fixed rate certificates of deposit and FHLBI advances that mature within one year, reflecting the fact that a majority of our loans and leases have a floating rate tied to either the Prime Rate or Libor. While this maturity strategy increases inherent liquidity risk, we believe the increased liquidity risk is sufficiently mitigated by the benefits derived from an interest rate risk management standpoint. In addition, we have developed a comprehensive contingency funding plan which we believe further mitigates the increased liquidity risk.

Wholesale funds are generally a lower all-in cost source of funds when compared to the interest rates that would have to be offered in our local markets to generate a commensurate level of funds. As has historically been the case, interest rates paid on new out-of-area deposits and FHLBI advances throughout 2007 were very similar to interest rates paid on new certificates of deposit issued to local customers. In addition, the overhead costs associated with wholesale funds are considerably less than the overhead costs that would be incurred to administer a similar level of local deposits, especially if the estimated costs of a required expanded branching network were taken into account. We believe the relatively low overhead costs reflecting our limited branch network mitigate our high reliance on wholesale funds and resulting relatively low net interest margin.

As a member of the FHLBI, our bank has access to the FHLBI’s borrowing programs. FHLBI advances totaled $135.0 million as of September 30, 2007, compared to $95.0 as of December 31, 2006. Based on available collateral as of September 30, 2007, we could borrow an additional $180.0 million. Our bank has the ability to borrow money on a daily basis through correspondent banks via established unsecured federal funds purchased lines, totaling $72.0 million as of September 30, 2007. The average balance of federal funds purchased during the first nine months of 2007 equaled $3.8 million.

In addition to typical loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of September 30, 2007, our bank had a total of $486.5 million in unfunded loan commitments and $87.9 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $412.6 million were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $73.9 million were for loan commitments expected to close and become funded within the next twelve months. We monitor fluctuations in loan balances and commitment levels and include such data in managing our overall liquidity.

We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, earnings problems, declining capital levels or situations beyond our control could cause either short or long term liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting both temporary and longer-term liquidity disruptions. Depending upon the particular circumstances of a liquidity situation, possible strategies may include obtaining funds via one or a combination of the following sources of funds: established lines of credit at correspondent banks and the FHLBI, brokered certificate of deposit market, wholesale securities repurchase markets, issuance of term debt, sale of assets, or sale of common stock or other securities.

Shareholders’ equity is a noninterest-bearing source of funds that provides support for asset growth. Shareholders’ equity increased by $5.8 million during the first nine months of 2007, from $171.9 million on December 31, 2006, to $177.7 million at September 30, 2007. The increase is primarily attributable to net income of $8.9 million recorded during the first nine months of 2007. Shareholders’ equity also increased $0.2 million from the issuance of new shares of common stock resulting from our dividend reinvestment plan, employee stock purchase plan and stock option exercises. Shareholders’ equity was negatively impacted during the first nine months of 2007 by the payment of cash dividends totaling $3.5 million.

We are subject to regulatory capital requirements primarily administered by federal bank regulatory agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. The capital ratios of the company and our bank as of September 30, 2007 and December 31, 2006 are disclosed under Note 9 of the Notes to Consolidated Financial Statements.

Our and our bank’s ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. We declared a 5% stock dividend on April 10, 2007, that was distributed on May 4, 2007 to record holders as of April 23, 2007. All earnings per share and cash dividend per share information have been adjusted for the 5% stock dividend. We paid a stock dividend-adjusted $0.13 per share cash dividend on March 9, 2007, and a $0.14 per share cash dividend on June 8, 2007 and September 10, 2007. On October 9, 2007, we declared a $0.14 per share cash dividend payable on December 10, 2007 to record holders as of November 9, 2007.

Net income for the third quarter of 2007 was $2.4 million ($0.28 per basic and diluted share), which represents a 54.5% decrease from net income of $5.2 million ($0.62 per basic share and $0.61 per diluted share) recorded during the third quarter of 2006. Net income for the first nine months of 2007 was $8.9 million ($1.05 per basic and diluted share), which represents a 41.8% decrease from net income of $15.2 million ($1.82 per basic share and $1.79 per diluted share) recorded during the first nine months of 2006. The decline in net income during both time periods is primarily the result of lower net interest income and a higher provision for loan and lease losses. In addition, net income for the first nine months of 2007 includes a one-time $1.2 million ($0.8 million after-tax) expense associated with the financial retirement package for former Chairman and Chief Executive Officer Gerald R. Johnson Jr. which was recorded during the second quarter of 2007 in conjunction with Mr. Johnson’s retirement effective June 30, 2007. Excluding this one-time expense, net income for the first nine months of 2007 was $9.7 million ($1.14 per basic and diluted share).

Interest income during the third quarter of 2007 was $36.8 million, an increase of 3.1% over the $35.7 million earned during the third quarter of 2006. Interest income during the first nine months of 2007 was $108.9 million, an increase of 8.3% over the $100.5 million earned during the first nine months of 2006. The growth in interest income during both time periods is primarily attributable to growth in earning assets. During the third quarter of 2007, earning assets averaged $1,992.1 million, $110.2 million higher than average earning assets of $1,881.9 million during the third quarter of 2006. Average loans were up $88.5 million and average securities increased $14.3 million. During the first nine months of 2007, earning assets averaged $1,970.4 million, $135.9 million higher than average earning assets of $1,834.5 million during the same time period in 2006. Average loans were up $119.9 million and average securities increased $16.8 million. Negatively impacting the growth in interest income was a decreasing yield on earning assets. During the third quarter of 2007 and 2006, earning assets had a weighted average yield (tax equivalent-adjusted basis) of 7.38% and 7.58%, respectively. During the first nine months of 2007 and 2006, earning assets had a weighted average yield of 7.45% and 7.39%, respectively. The recent decline in our yield on earning assets is directly attributable to a decline in the yield of our commercial loan portfolio, primarily reflecting an increase in nonaccrual commercial loans and corresponding reduction in interest income, and a very competitive lending environment. These factors resulted in relatively low interest rates on many new commercial loans relationships and the reduction of interest rates on certain existing commercial loan relationships during the past 12 to 18 months.

Interest expense during the third quarter of 2007 was $22.7 million, an increase of 12.9% over the $20.1 million expensed during the third quarter of 2006. Interest expense during the first nine months of 2007 was $66.4 million, an increase of 22.5% over the $54.2 million expensed during the first nine months of 2006. The growth in interest expense is primarily attributable to the increase in interest-bearing liabilities necessitated by asset growth and a higher cost of funds. During the third quarter of 2007, interest-bearing liabilities averaged $1,780.9 million, $97.0 million higher than average interest-bearing liabilities of $1,683.9 million during the third quarter of 2006. Interest-bearing deposits were up $63.9 million, repurchase agreements increased $21.0 million and FHLBI advances were up $11.8 million. During the first nine months of 2007, interest-bearing liabilities averaged $1,763.2 million, $123.9 million higher than average interest-bearing liabilities of $1,639.3 million during the same time period in 2006. Interest-bearing deposits were up $123.5 million and repurchase agreements increased $15.2 million, while FHLBI advances declined $15.5 million. During the third quarter of 2007 and 2006, interest-bearing liabilities had a weighted average rate of 5.06% and 4.74%, respectively. During the first nine months of 2007 and 2006, interest-bearing liabilities had a weighted average rate of 5.04% and 4.42%, respectively. The higher weighted average cost of interest-bearing liabilities primarily results from maturing fixed rate certificates of deposit and FHLBI advances that were originated in lower interest rate environments that have been renewed or replaced with similar products in the current higher interest rate environment.

Net interest income during the third quarter of 2007 was $14.1 million, a decline of 9.6% from the $15.5 million earned during the third quarter of 2006. Net interest income during the first nine months of 2007 was $42.5 million, a decline of 8.2% from the $46.3 million earned during the same time period in 2006. The decrease in net interest income is primarily due to a decline in the net interest margin resulting from a declining yield on assets and a higher average rate on interest-bearing liabilities, which more than offset the positive impact from growth in earning assets. The net interest margin during the third quarter of 2007 was 2.86%, compared to the 3.34% during the third quarter of 2006. During the first nine months of 2007, the net interest margin was 2.94%, compared to 3.44% during the same time period in 2006.

The following table sets forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the third quarter of 2007 and 2006. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 35%. Securities interest income was increased by $300,000 and $296,000 in the third quarter of 2007 and 2006, respectively, for this adjustment.