UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003
For the transition period from to
Commission file number 000-23423
C&F Financial Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)
(804) 843-2360
(Registrant’s telephone number)
(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. x Yes No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
¨ Yes No x
At November 7, 2003, the latest practicable date for determination, 3,612,171 shares of common stock, $1.00 par value, of the registrant were outstanding.
TABLE OF CONTENTS
Part I—Financial Information
Item 1.
Item 2.
Item 3.
Item 4.
Part II—Other Information
Item 6.
Signatures
PART I—FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share and per share amounts)
ASSETS
Cash and due from banks
Interest-bearing deposits in other banks
Total cash and cash equivalents
Securities-available for sale at fair value, amortized cost of $51,056 and $57,726, respectively
Loans held for sale, net
Loans, net
Federal Home Loan Bank stock
Corporate premises and equipment, net of accumulated depreciation
Accrued interest receivable
Goodwill
Other assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
Non-interest-bearing demand deposits
Savings and interest-bearing demand deposits
Time deposits
Total deposits
Borrowings
Accrued interest payable
Other liabilities
Total liabilities
Commitments and contingent liabilities
Shareholders’ equity
Preferred stock ($1.00 par value, 3,000,000 shares authorized)
Common stock ($1.00 par value, 8,000,000 shares authorized, 3,607,371 and 3,649,859 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively)
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income net of tax of $1,087 and $987, respectively
Total shareholders’ equity
Total liabilities and shareholders’ equity
The accompanying notes are an integral part of the consolidated financial statements.
1
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended
September 30,
Nine Months Ended
Interest income
Interest and fees on loans
Interest on other investments and fed funds
Interest on investment securities
U.S. government agencies and corporations
Tax-exempt obligations of states and political subdivisions
Corporate bonds and other
Total interest income
Interest expense
Savings and interest-bearing deposits
Certificates of deposit, $100 or more
Other time deposits
Other borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Other operating income
Gain on sale of loans
Service charges on deposit accounts
Other service charges and fees
Gain on maturities and calls of available for sale securities
Other income
Total other operating income
Other operating expenses
Salaries and employee benefits
Occupancy expenses
Other expenses
Total other operating expenses
Income before income taxes
Income tax expense
Net income
Per share data
Net income—basic
Net income—assuming dilution
Cash dividends paid and declared
Weighted average number of shares—basic
Weighted average number of shares—assuming dilution
2
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands)
Common
Stock
Additional
Paid-In
Capital
Comprehensive
Income
Retained
Earnings
Accumulated
Other
Beginning balance December 31, 2002
Comprehensive income
Other comprehensive income, net of tax
Unrealized gain on securities, net of reclassification adjustment1
Stock options exercised
Repurchase of common stock
Cash dividends
Ending balance September 30, 2003
1Disclosure of Reclassification Amount:
Unrealized net holding gains arising during period
Less: reclassification adjustment for gains included in net income
Net unrealized gains on securities
3
Beginning balance December 31, 2001
Issuance of common stock in connection with acquisition
Ending balance September 30, 2002
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation
Amortization of intangible assets
Accretion of discounts and amortization of premiums on investment securities, net
Net realized gain on securities
Proceeds from sale of loans
Origination of loans held for sale
Change in other assets and liabilities:
Net cash provided by operating activities
Cash flows from investing activities:
Proceeds from maturities and calls of securities available for sale
Purchase of securities available for sale
Net increase in customer loans
Purchase of corporate premises and equipment
Sale of corporate premises and equipment
Purchase (redemption) of Federal Home Loan Bank stock
Acquisition of subsidiary
Net cash used in investing activities
Cash flows from financing activities:
Net increase in demand, interest bearing demand and savings deposits
Net increase in time deposits
Net decrease in other borrowings
Proceeds from exercise of stock options
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
5
Supplemental disclosure
Interest paid
Income taxes paid
Transactions related to the acquisition of subsidiary:
Issuance of common stock
Issuance of debt
Increase in assets and liabilities:
Loans
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial reporting and with applicable quarterly reporting regulations of the Securities and Exchange Commission. They do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the C&F Financial Corporation Annual Report on Form 10-K for the year ended December 31, 2002.
In the opinion of C&F Financial Corporation’s management, all adjustments, consisting only of normal recurring accruals, necessary to present fairly the financial position as of September 30, 2003, the results of operations for the three and nine months ended September 30, 2003 and 2002 and cash flows for the nine months ended September 30, 2003 and 2002 have been made. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.
The consolidated financial statements include the accounts of C&F Financial Corporation (the “Company”) and its subsidiary, Citizens and Farmers Bank (the “Bank”), with all significant intercompany transactions and accounts being eliminated in consolidation.
Stock Compensation Plans: The Company has three stock-based compensation plans that are accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the pro forma effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation (in thousands, except per share amounts).
Net income, as reported
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net income
Earnings per share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
7
Total stock-based compensation expense
determined under fair value based method for all awards, net of related tax effects
Note 2
Net income per share assuming dilution has been calculated on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding for the applicable periods.
Note 3
During the first nine months of 2003, the Company repurchased 80,000 shares of its common stock in privately negotiated transactions at prices between $28.00 and $28.50 per share. The Company did not repurchase any shares of its common stock during the first nine months of 2002.
Note 4
On September 1, 2002, the Bank acquired Moore Loans, Inc. Moore Loans is a leading regional finance company providing automobile loans in Richmond, Roanoke and Hampton Roads, Virginia and portions of eastern Tennessee. Under the terms of the acquisition, the outstanding shares of Moore Loans’ common stock were purchased for $11.0 million in cash, $3.0 million in subordinated notes of the Bank, 100,000 shares of the Company’s common stock and up to an additional $3.0 million in cash contingent on Moore Loans attaining certain financial goals within the next three years, of which $337,000 was earned in 2002. Also, the Company has guaranteed a stock price of $30 per share for shares still held by the sellers on the three-year anniversary date of the transaction. The transaction was accounted for using the purchase method of accounting. The purchase price of $16.3 million was allocated to the assets acquired and liabilities assumed as follows (in thousands):
Liabilities assumed
Total purchase price
8
The results of operations of Moore Loans are included in the financial statements from the acquisition date. The following table presents pro forma combined results of operations of C&F Financial Corporation and Moore Loans for the three months and nine months ended September 30, 2002 as if the business combination had been completed as of the beginning of 2002 (in thousands, except per share amounts):
September 30, 2002
Earnings per share—assuming dilution
Note 5
The Company operates in a decentralized fashion in three principal business activities: retail banking, mortgage banking and consumer finance. Revenues from retail banking operations consist primarily of interest earned on loans and investment securities. Mortgage banking operating revenues consist principally of interest earned on mortgage loans held for sale, gains on sales of loans in the secondary mortgage market and loan origination fee income. Revenues from consumer finance activities consist primarily of interest earned on automobile loans. The Company also has investment company, title company, settlement company and insurance company subsidiaries that derive revenues from brokerage, title insurance, mortgage loan settlement and insurance services, respectively. The results of these other subsidiaries are not significant to the Company as a whole and have been included in “Other.” The following table presents segment information for the three and nine months ended September 30, 2003 and 2002.
Retail
Banking
Mortgage
Consumer
Finance
Revenues:
Total operating income
Expenses:
Personnel expenses
Total operating expenses
Provision for income taxes
Capital expenditures
9
10
Nine Months Ended September 30, 2002
The Retail Banking segment provides the Mortgage Banking segment with the funds needed to originate mortgage loans through a warehouse line of credit and charges the Mortgage Banking segment interest at the daily Federal Home Loan Bank advance rate plus 50 basis points. The Retail Banking segment also provides the Consumer Finance segment with a portion of the funds needed to originate loans and charges the Consumer Finance segment interest at LIBOR plus 250 basis points. These transactions are eliminated to reach consolidated totals. Certain corporate overhead costs incurred by the Retail Banking segment are not allocated to the Mortgage Banking, Consumer Finance and Other segments.
11
Forward-Looking Statements
The statements contained in this report that are not historical facts may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in: interest rates, general economic conditions, legislation and regulations, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the loan or investment portfolios, demand for loan products, including residential home mortgages, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date of this report.
The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of C&F Financial Corporation (the “Company”). This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.
Critical Accounting Policies
Allowance for Loan Losses: The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when management believes that the collectibility of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the adequacy of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as changes in the nature and volume of the loan portfolio, current economic conditions which may affect a borrower’s ability to repay, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
Impaired Loans: Impaired loans are measured based on the present value of expected future cash flows discounted at the effective interest rate of the loan (or, as a practical expedient, at the loan’s observable market price) or the fair value of the collateral if the loan is collateral dependent. The Company considers a loan impaired when it is probable that the Company will be unable to collect all interest and principal payments as scheduled in the loan agreement. A loan is not considered impaired during a period of delay in payment if the ultimate collection of all amounts due is expected. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.
12
Valuation of Derivatives: The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e., rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 45 to 120 days. For such rate lock commitments, the Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby an investor commits to buy the loan at the time the borrower commits to an interest rate with the intent that the investor has assumed the interest rate risk on the loan.
The Company does not hold any derivative instruments in its securities portfolio nor has it entered into any other derivative hedging transactions.
Goodwill: On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. In assessing the recoverability of the Company’s goodwill, all of which was recognized in connection with the Bank’s acquisition of Moore Loans, Inc. in September 2002, management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, the Company may be required to record impairment charges not previously recorded.
Defined Benefit Pension Plan: The Bank maintains a non-contributory, defined benefit pension plan for eligible full-time employees as defined by the plan. Plan assets, which consist primarily of marketable equity securities and corporate and government fixed income securities, are valued using market quotations. Plan obligations and annual pension and postretirement benefit income are determined by actuaries using a number of key assumptions. Key assumptions include the discount rate, the estimated future return on plan assets, and the anticipated rate of future salary increases. Changes in these assumptions, if any, may impact pension expense as measured in accordance with SFAS No. 87,Employers’ Accounting for Pensions.
Stock Compensation Plans: SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of Statement No. 123 (“SFAS 148”) was issued in December 2002. SFAS 148 amends SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to, among other things, provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Currently, the Company’s three stock-based compensation plans are accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, no stock-based compensation cost is reflected in the Company’s net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. If the Company elects to adopt the recognition provisions of SFAS 148 in 2003, the change in accounting principle will result in a stock-based compensation cost to be reflected in the Company’s net income. The amount of compensation cost will be dependent on the fair value based method chosen.
13
Overview
Net income increased 25.1% to $3.4 million for the three months ended September 30, 2003 compared to $2.7 million for the same period of 2002. Earnings per diluted share were $.89 for the three month period of 2003, up 20.3% from $.74 per diluted share for the three months ended September 30, 2002. Net income increased 49.4% to $10.2 million for the nine months ended September 30, 2003 compared to $6.8 million for the same period of 2002. Earnings per diluted share were $2.69 for the nine month period of 2003, up 43.1% from $1.88 per diluted share for the nine months ended September 30, 2002.
Performance as measured by the Company’s annualized return on average assets (ROA) was 2.38% for the three months ended September 30, 2003 compared to 2.41% for the same period of 2002. For the first nine months of 2003, ROA was 2.50% compared to 2.08% for the first nine months of 2002. Another key indicator of performance, the annualized return on average equity (ROE), was 21.74% for the three months ended September 30, 2003 compared to 21.06% for the three months ended September 30, 2002. For the nine months ended September 30, 2003, ROE was 22.80% compared to 18.84% for the first nine months of 2002.
The increase in net income and earnings per share for both the third quarter and the nine months ended September 30, 2003 resulted primarily from an increase in the earnings of the Mortgage Banking segment and the inclusion of the earnings of the Consumer Finance segment, which was acquired in September 2002. The results of operations of each of the Company’s significant business segments are summarized below.
Retail Banking: Earnings for the Retail Banking segment were $1.1 million and $3.6 million for the third quarter and the first nine months, respectively, of 2003, as compared to $1.3 million and $3.8 million for the third quarter and the first nine months, respectively, of 2002. Included in earnings for 2002 was a non-recurring tax-free insurance benefit of $277,000, which was received in the second quarter of 2002. Excluding this benefit, recurring earnings for the Retail Banking segment were $3.5 million for the first nine months of 2002. The following table presents the reconciliation of the change in net income of the Retail Banking segment to the increase in recurring earnings for the nine months ended September 30, 2003 and 2002.
Nonrecurring insurance benefit
Recurring earnings1
1The presentation of this non-GAAP financial measure is meaningful to the discussion of comparative earnings for the Retail Banking segment for the nine months ended September 30, 2003 and 2002 because the decline in net income, as reported, is not indicative of the trend in earnings for the Retail Banking segment.
The decline in earnings for the comparative third quarter periods is primarily a result of an increase in the provision for loan losses resulting from a higher level of non-accrual loans and accruing loans past due 90 days or more and higher operating expenses resulting from the initial costs associated with the expansion of the Retail Banking segment. During the third quarter of 2003, the Retail Banking segment opened a new branch in Mechanicsville, Virginia and began to hire individuals for the expansion into the Virginia Peninsula region.
14
The increase in recurring earnings for the comparative nine month periods is primarily a result of higher average earning assets, principally funded by growth in deposits, and an increase in recurring non-interest income, partially offset by an increase in non-interest expense. The increase in average earning assets is a result of a higher average balance of loans by the Retail Banking segment to the Mortgage Banking and the Consumer Finance segments, as well as an increase in loans to third party customers. The increase in recurring non-interest income is primarily a result of the new overdraft program implemented by the Bank during 2002 and the gain on calls of securities that resulted from the low interest rate environment. The increase in non-interest expense is primarily a result of an increase in salaries and benefits as the Bank continues to add staff to support growth.
Mortgage Banking: Earnings for the Mortgage Banking segment increased approximately $591,000 to $1.7 million for the quarter ended September 30, 2003 and increased approximately $2.1 million to $4.7 million for the nine months ended September 30, 2003. The increase in earnings is a result of the continued low interest rate environment and strong demand for mortgage loans, as well as the October 2002 addition of a new loan production office in Fredericksburg, Virginia and an increase in loan officers at existing loan production offices. Income at C&F Mortgage Corporation is generally correlated to changes in interest rates and new and resale home purchases. The low interest rates and strong home sales have resulted in strong demand for both mortgage loans to refinance existing loans, as well as mortgage loans for new and resale home purchases. For the third quarter of 2003, the amount of loan originations at C&F Mortgage resulting from refinancing was $163.7 million compared to $97.2 million for the third quarter of 2002. Loans originated for new and resale home purchases for these two time periods were $174.2 million and $113.1 million, respectively. For the first nine months of 2003, the amount of loan originations at C&F Mortgage resulting from refinancing was $468.3 million compared to $191.2 million for the same period of 2002. Loans originated for new and resale home purchases for these two time periods were $432.3 million and $312.1 million, respectively. C&F Mortgage expects that future earnings of the Mortgage Banking segment will be affected by changes in interest rates and demand for new and resale home sales. The recent increase in mortgage rates has resulted in a decline in the number of applications, which will ultimately result in a decrease in originations and sales of loans.
Consumer Finance: Earnings for the Consumer Finance segment, consisting solely of Moore Loans, Inc., totaled $507,000 for the quarter ended September 30, 2003 and $1.6 million for the nine months ended September 30, 2003. Three and nine month earnings for 2002 were $214,000 from September 1, the date of acquisition, through September 30.
RESULTS OF OPERATIONS
Net Interest Income
The following table presents the average balances of interest-earning assets with related yields and interest-bearing liabilities with related rates. Loans include loans held for sale. Loans placed on a non-accrual status are included in the balances and in the computation of yields, upon which they had an immaterial effect. The yields on tax-exempt earning assets are on a taxable-equivalent basis, which converts the income on tax-free loans and investments to the equivalent yield as if taxes were paid using the federal corporate income tax rate of 34%.
15
Selected Average Balance Sheet Data
Securities
Fed funds sold / interest bearing deposits at other banks
Total earning assets
Time, checking and savings deposits
Total interest bearing liabilities
Net interest margin
Net interest income, on a taxable equivalent basis, for the three months ended September 30, 2003 was $7.8 million, an increase of $2.0 million, or 35.5%, from $5.7 million for the three months ended September 30, 2002. Net interest income, on a taxable equivalent basis, for the nine months ended September 30, 2003 was $23.3 million, an increase of $8.3 million, or 55.6%, from $15.0 million for the comparable period in 2002. These increases resulted from higher average interest earning assets, which increased 25.5% for the third quarter of 2003 and 28.7% for the first nine months of 2003, and from increases in the net interest margin, which increased to 5.99% for the third quarter of 2003 from 5.55% for the same period in 2002 and to 6.23% for the first nine months of 2003 from 5.14% for the first nine months of 2002. The increases in average earning assets for the three and nine month periods ended September 30, 2003 were a result of an increase in the average balance of loans, offset in part by a decrease in the average balance of interest earning deposits at other banks (primarily at the Federal Home Loan Bank (“FHLB”)) and a decrease in the average balance of securities.
16
The increase in average loans is a result of an increase in loans at the Bank, the acquisition of Moore Loans and an increase in loans held for sale at C&F Mortgage. The increase in average loans at the Bank approximated $21.4 million for the third quarter of 2003 and $25.2 million for the first nine months of 2003. This increase was a result of overall growth due to loan demand. The average balance of loans at Moore Loans, which was acquired September 1, 2002, was $77.3 million for the third quarter of 2003 and $73.3 million for the first nine months of 2003. The increase in average loans at C&F Mortgage approximated $53.3 million and $39.6 million for the third quarter and first nine months, respectively, of 2003, which resulted from an increase in originations at C&F Mortgage. Loans originated and loans sold at C&F Mortgage for the third quarter of 2003 were $337.9 million and $366.5 million, respectively, compared to $210.6 million and $182.5 million, respectively, for the third quarter of 2002. Loans originated and loans sold at C&F Mortgage for the first nine months of 2003 were $900.6 million and $937.4 million, respectively, compared to $503.3 million and $496.8 million, respectively, for the comparable period in 2002.
The decrease in the average balance of securities available for sale for the three month and nine month periods ended September 30, 2003 resulted from maturities and calls of higher-yielding securities. Funds provided from the decline in securities available for sale and from the reduction in lower-yielding interest-bearing deposits at other banks were deployed into higher-yielding loans.
The increase in the Company’s net interest margin on a taxable equivalent basis for the third quarter of 2003 compared to the third quarter of 2002 was a result a decrease in the cost of funds to 2.09% from 2.66%. The yield on interest earnings assets was 7.71% for both the third quarter of 2003 and 2002. The decline in the yield on loans to 7.93% from 8.25% was offset by the decline in the average balance of interest-bearing deposits at other banks. The decline in the yield on loans resulted from a 25 basis point decline in the Bank’s prime rate in the third quarter of 2003, coupled with an increase in the average balance of lower yielding loans held for sale at C&F Mortgage, which more than offset the increase in the average balance of higher-yielding loans of the Consumer Finance segment. The decline in the average balance of interest-bearing deposits in other banks was a result of an increase in loans held for sale. The Company’s net interest margin, on a taxable equivalent basis, for the first nine months of 2003 compared to the same period of 2002 increased as a result of an increase in the yield on interest earning assets to 8.05% from 7.41%, coupled with a decrease in the cost of funds to 2.20% from 2.79%. The yield on interest earning assets was favorably impacted by the higher yield on average loans at Moore Loans relative to the Bank and C&F Mortgage. For the three months and nine months ended September 30, 2003, Moore Loans had average loans of $77.3 million and $73.3 million, respectively, with individual loan rates ranging from 15% to 20%. The favorable impact of Moore Loans’ yield was reduced by a decrease in the yield on loans held by the Bank resulting from the low interest rate environment and an increase in the average balance of lower yielding loans held for sale at C&F Mortgage.
The taxable-equivalent yield on the Company’s securities portfolio declined from 7.29% for the third quarter of 2002 to 7.23% for the third quarter of 2003 and from 7.44% for the first nine months of 2002 to 7.23% for the comparable period in 2003 as a result of the maturities and calls of higher-yielding securities.
The decrease in the cost of funds for the Company for the third quarter and for the first nine months of 2003 was a result of the falling interest rate environment and the repricing of maturing certificates of deposit at lower rates, offset in part by higher-cost funds related to Moore Loans. Moore Loans has a line of credit with an unrelated third party, which bears interest at LIBOR plus 250 basis points. In addition, as part of the acquisition of Moore Loans, the Bank borrowed $20 million from the FHLB at rates between 2.8% and 3.3% and $5 million from an unrelated third party, which bears
17
interest at 6.0%. As part of the purchase price of Moore Loans, the Bank issued $3 million in subordinated debt to the former shareholders of Moore Loans, which bears interest at 8.0%.
While low interest rates have resulted in downward pressure on asset yields, banks have not been able to reduce deposit costs at the same pace.
Non-Interest Income
Gain on calls of available for sale securities
Total non-interest income
Total non-interest income1
18
Recurring non-interest income1
Total non-interest income increased $2.3 million or 39.8% to $8.0 million for the three months ended September 30, 2003 from $5.7 million for the three months ended September 30, 2002. Total non-interest income increased $8.2 million or 55.2% to $22.9 million for the first nine months of 2003 from $14.8 million for the same period in 2002. The three month and nine month increases in 2003 were mainly attributable to an increase in gains on the sale of loans and other service charges and fees resulting from an increase in the volume of loans closed and sold by C&F Mortgage. The increase in total non-interest income for the three and nine months ended September 30, 2003 also included an increase in service charges at the Retail Banking segment, resulting from the Bank’s new overdraft program that was started at the beginning of 2002.
Occupancy expense
Total non-interest expense
Three Months Ended September 30, 2002
19
Nine Months Ended September 30, 2003
Total non-interest expense increased $2.6 million, or 37.6%, to $9.5 million for the three months ended September 30, 2003 from $6.9 million for the three months ended September 30, 2002. Total non-interest expenses increased $9.0 million, or 48.4%, to $27.7 million for the first nine months of 2003 from $18.7 million for the first nine months of 2002. The three month and nine month increases in 2003 were mainly attributable to the acquisition of Moore Loans in September 2002, coupled with higher variable compensation costs and other operating expenses at C&F Mortgage Corporation resulting from the increase in loan production. In addition, the increase in personnel expenses at the Retail Banking segment was a result of an increase in operations and administrative personnel, coupled with higher employee benefits expense, which were attributable to continued growth and higher pension and health care costs, respectively.
Income Taxes
Income tax expense for the third quarter of 2003 totaled $1.7 million, an effective tax rate of 33.6%, compared to $1.2 million, or 31.6%, for the third quarter of 2002. Income tax expense for the first nine months of 2003 totaled $5.1 million, an effective tax rate of 33.3%, compared to $2.8 million, or 28.9%, for the first nine months of 2002. The increase in the effective tax rate for the three months and nine months ended September 30, 2003 was a result of a decrease in earnings from tax-exempt assets as a percentage of total income mainly resulting from the increased earnings at C&F Mortgage and Moore Loans and to the receipt of a non-recurring insurance benefit in the second quarter of 2002 that was not subject to income taxes.
Asset Quality
Allowance for Loan Losses
The allowance for loan losses represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. The allowance is increased by the provision for loan losses and reduced by loans charged off, net of recoveries. The following table summarizes the allowance activity for periods indicated:
Allowance, beginning of period
Loans charged off
Recoveries of loans previously charged off
Net loans charged off
Allowance, end of period
Acquisition of Moore Loans
21
The Consumer Finance segment, consisting solely of Moore Loans, accounted for the majority of the activity in the allowance for loan losses during the third quarter and the first nine months of 2003. Moore Loans serves customers who have limited access to traditional automobile financing. Moore Loans’ typical borrowers have experienced prior credit difficulties or have modest income. Because Moore Loans serves customers who are unable to meet the credit standards imposed by most traditional automobile financing sources, Moore Loans expects to sustain a higher level of credit losses than traditional automobile financing sources. As Moore Loans provides financing in a relatively higher risk market, Moore Loans generally charges interest at higher rates than those charged by traditional financing sources.
In addition to maintaining the allowance for loan losses, Moore Loans retains dealer reserves that are established at the time a loan is made and are specific to each individual dealer. Loans charged off at Moore Loans are first charged to the dealer reserves, to the extent that an individual dealer has reserves, and the remainder is charged to the allowance for loan losses. Dealer reserves are a liability of Moore Loans and payable to individual dealers upon the termination of the relationship with Moore Loans and the payment of outstanding loans associated with a specific dealer.
22
The following table summarizes the dealer reserves activity (dollars in 000’s):
September 30, 2003
Dealer reserves, beginning of period
Reserve holdback at loan origination
Dealer reserves, end of period
During periods of economic slowdown or recession, delinquencies, defaults, repossessions and losses generally increase at the Consumer Finance segment. These periods also may be accompanied by decreased consumer demand for automobiles and declining values of automobiles securing outstanding loans, which weakens collateral coverage and increases the amount of a loss in the event of default. Significant increases in the inventory of used automobiles during periods of economic recession may also depress the prices at which repossessed automobiles may be sold or delay the timing of these sales.
Non-Performing Assets
Retail and Mortgage Banking
2003
December 31,
2002
Non-accrual loans
Real estate owned
Total non-performing assets
Accruing loans past due for 90 days or more
Allowance for loan losses
Non-performing assets to total loans* and real estate owned
Allowance for loan losses to total loans* and real estate owned
Allowance for loan losses to non-performing assets
*Total loans above excludes consumer finance loans at Moore Loans.
Consumer Finance
Dealer reserves
Non-accrual loans to total loans
Allowance for loan losses and dealer reserves to non-accrual loans
Allowance for loan losses to total consumer finance loans
Dealer reserves to total consumer finance loans
Allowance for loan losses and dealer reserves to total consumer finance loans
There has been no significant change in non-performing assets of the combined Retail and Mortgage Banking segments, which increased to $2.7 million at September 30, 2003 from $2.4 million at December 31, 2002. Accruing loans past due for 90 days or more increased to $824,000 at September 30, 2003 from $69,000 at December 31, 2002. This increase did not result from a single relationship or concentration; rather it occurred in individually small-balance loans. Real estate owned consists primarily of two commercial properties, one of which was sold after September 30, 2003. A reserve for the projected loss on this sale, while not significant, was included in earnings for the third quarter and
23
the first nine months of 2003. The allowance for loan losses was $4.2 million at September 30, 2003 and $3.8 million at December 31, 2002, which approximates 1.50% and 1.40%, respectively, of total loans and real estate owned. This increase is a result of the slightly higher level of non-accrual loans and accruing loans past due 90 days or more. Management believes that the current allowance is adequate to absorb any losses on existing loans that may become uncollectible in the combined Retail and Mortgage Banking segments.
Non-accrual assets of the Consumer Finance segment increased to $1.1 million at September 30, 2003 from $688,000 at December 31, 2002. The corresponding allowance for loan losses was $3.9 million at September 30, 2003 and $3.0 million at December 31, 2002, and dealer reserves were $2.2 million at September 30, 2003 and $2.1 million at December 31, 2002. The ratio of the combined allowance for loan losses and dealer reserves to total consumer finance loans increased to 7.76% at September 30, 2003 from 7.48% at December 31, 2002 as a result of the higher level of non-accrual loans and the increase in charge-off activity. Because Moore Loans focuses on non-prime borrowers, the actual rates of delinquencies, defaults, repossessions and losses on these loans are higher than those experienced in the general automobile finance industry and could be more dramatically affected by a general economic downturn. While Moore Loans seeks to manage the higher risk inherent in loans made to non-prime borrowers through underwriting criteria and collection methods it employs, no assurance can be given that these criteria or methods will afford adequate protection against these risks. However, management believes that the current allowance for loan losses and dealer reserves are adequate to absorb any losses on existing loans in the Consumer Finance segment that may become uncollectible.
FINANCIAL CONDITION
At September 30, 2003, the Company had total assets of $564.7 million compared to $551.9 million at December 31, 2002. The increase was principally a result of a $33.4 million increase in total cash and cash equivalents and a $20.6 million increase in total loans held for investment as presented below. These increases were partially offset by a $6.4 million decline in available-for-sale securities resulting from maturities and calls of higher-yielding securities in the low interest rate environment, and a $36.8 million decline in the balance of loans held for sale, which fluctuates based on originations and loan sales at C&F Mortgage. During the first nine months of 2003 loan sales were $937.4 million and loan originations were $900.6 million.
24
Loan Portfolio
The following table sets forth the composition of the Company’s loans held for investment in dollar amounts and as a percentage of the Company’s total gross loans held for investment at the dates indicated (dollars in 000’s):
Real estate—mortgage
Real estate—construction
Commercial, financial and agricultural
Equity lines
Consumer—Moore Loans
Total loans
Less unearned loan fees
Less allowance for loan losses
Total loans, net
Investment Securities
At September 30, 2003, total investment securities were $54.3 million compared to $60.6 million at December 31, 2002. Mortgage backed securities represented 4.4% of the total securities portfolio, obligations of state and political subdivisions were 82.6%, U.S. government agency notes were 2.0% and preferred stocks were 11.0% at September 30, 2003. Mortgage backed securities represented 7.2% of the total securities portfolio, obligations of states and political subdivisions were 83.5% and preferred stocks were 9.3% at December 31, 2002.
Deposits totaled $415.9 million at September 30, 2003 compared to $383.5 million at December 31, 2002. Non-interest bearing deposits totaled $63.0 million at September 30, 2003 compared to $53.4 million at December 31, 2002. The increase in deposits is primarily a result of an increase in deposits at branches that were opened in the last quarter of 2001, and the result of investors moving funds from stocks and mutual funds to banks.
Other Borrowings
Borrowings totaled $75.6 million at September 30, 2003 compared to $94.5 million at December 31, 2002. This decrease occurred in short-term borrowings from the FHLB. There were no short-term advances from the FHLB outstanding on September 30, 2003 compared to $29.0 million outstanding on December 31, 2002. The decrease in short-term advances was primarily a result of the decline in loans held for sale, which are funded in part by FHLB advances, and an increase in deposits. The decline in FHLB advances was offset in part by a $10.0 million increase in the non-recourse revolving line of credit with a third party bank that partially funds loans at Moore Loans.
25
Liquidity
At September 30, 2003, cash, securities classified as available for sale and interest-bearing deposits in other banks were 20.1% of total earning assets compared to 15.3% at December 31, 2002. Asset liquidity is also provided by managing the investment maturities.
Additional sources of liquidity available to the Company include the Bank’s capacity to borrow additional funds through an established federal funds line with a regional correspondent bank, an established line with the FHLB and a revolving line of credit with a third party bank.
Capital Resources
The Company’s and the Bank’s actual capital amounts and ratios are presented in the following table.
Minimum Capital
Requirements
Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions
(dollars in 000’s)
As of September 30, 2003:
Total Capital (to Risk-Weighted Assets)
Company
Bank
Tier I Capital (to Risk-Weighted Assets)
Tier I Capital (to Average Assets)
As of December 31, 2002:
Recent Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 elaborates on the disclosures to be made by a guarantor in its financial statements under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 requires disclosure of the nature of the guarantee, the maximum potential amount of future payments that the guarantor could be required to make under the guarantee, and the current amount of the liability, if any, for the guarantor’s obligations under the guarantee. The recognition requirements of FIN 45 were effective beginning
26
January 1, 2003. Management does not anticipate that the recognition requirements of FIN 45 will have a material impact on the Company’s consolidated financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 provides guidance with respect to the identification of variable interest entities and when the assets, liabilities, noncontrolling interests, and results of operations of a variable interest entity need to be included in a corporation’s consolidated financial statements. FIN 46 requires consolidation by business enterprises of variable interest entities in cases where the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity, or in cases where the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity’s activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and applies to previously existing entities beginning in the fourth quarter of 2003. Management is currently evaluating the applicability of FIN 46 but the adoption of FIN 46 is not expected to have a material impact on the Company’s consolidated financial statements.
In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective for contracts entered into or modified after June 30, 2003 and is not expected to have an impact on the Company’s consolidated financial statements.
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. Adoption of the Statement did not result in an impact on the Company’s consolidated financial statements.
Effects of Inflation
The effect of changing prices on financial institutions is typically different from other industries as the Company’s assets and liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price level indices. Impacts of inflation on interest rates, loan demand and deposits are reflected in the consolidated financial statements.
There have been no significant changes from the quantitative and qualitative disclosures made in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
27
The Company, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14 as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are operating effectively in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings. No significant changes in the Company’s internal control over financial reporting occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
28
PART II—OTHER INFORMATION
There are no material pending or threatened legal proceedings to which the Company is a party or of which property of the Company is subject.
On July 24, 2003, the Company filed a report on Form 8-K to announce the Company’s financial results for the second quarter ended June 30, 2003.
On August 21, 2003, the Company filed a report on Form 8-K to announce its declaration of a cash dividend payable October 1, 2003.
29
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.
C&F FINANCIAL CORPORATION
(Principal Financial and Accounting Officer)
30