City Holding Company - 10-Q quarterly report FY

All statements other than statements of historical fact included in this Quarterly Report on Form 10-Q, including statements in Management’s Discussion and Analysis of Financial Condition and Result of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such information involves risks and uncertainties that could result in the Company’s actual results differing from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include, but are not limited to:  (1) the Company may incur additional provision for loan losses due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (2) the Company may incur increased charge-offs in the future; (3) the Company may experience increases in the default rates or decreased prepayments on previously securitized loans that would result in impairment losses or lower the yield on such loans; (4) the Company may continue to benefit from strong recovery efforts on previously securitized loans resulting in improved yields on this asset; (5) the Company could have adverse legal actions of a material nature; (6) the Company may face competitive loss of customers; (7) the Company may be unable to manage its expense levels; (8) the Company may have difficulty retaining key employees; (9) changes in the interest rate environment may have results on the Company’s operations materially different from those anticipated by the Company’s market risk management functions; (10) changes in general economic conditions and increased competition could adversely affect the Company’s operating results; (11) changes in other regulations and government policies affecting bank holding companies and their subsidiaries, including changes in monetary policies, could negatively impact the Company’s operating results; and (12) the Company may experience difficulties growing loan and deposit balances. Forward-looking statements made herein reflect management’s expectations as of the date such statements are made. Such information is provided to assist stockholders and potential investors in understanding current and anticipated financial operations of the Company and is included pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances that arise after the date such statements are made.

The accompanying consolidated financial statements, which are unaudited, include all of the accounts of City Holding Company (“the Parent Company”) and its wholly-owned subsidiaries (collectively, “the Company”). All material intercompany transactions have been eliminated. The consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations and financial condition for each of the periods presented. Such adjustments are of a normal recurring nature. The results of operations for the six months ended June 30, 2007 are not necessarily indicative of the results of operations that can be expected for the year ending December 31, 2007. The Company’s accounting and reporting policies conform with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Such policies require management to make estimates and develop assumptions that affect the amounts reported in the consolidated financial statements and related footnotes. Actual results could differ from management’s estimates.

The consolidated balance sheet as of December 31, 2006 has been derived from audited financial statements included in the Company’s 2006 Annual Report to Shareholders. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2006 Annual Report of the Company.

Certain amounts in the 2005 financial statements have been reclassified to conform to the 2006 presentation. Such reclassifications had no impact on net income or shareholders’ equity.

Between 1997 and 1999, the Company completed six securitization transactions involving approximately $760 million in 125% of fixed rate, junior-lien underlying mortgages.  The Company retained a financial interest in each of the securitizations until 2004.  Principal amounts owed to investors were evidenced by securities (“Notes”).  During 2003 and 2004, the Company exercised its early redemption options on each of those securitizations.  Once the Notes were redeemed, the Company became the beneficial owner of the mortgage loans and recorded the loans as assets of the Company within the loan portfolio.  The table below summarizes information regarding delinquencies, net credit recoveries, and outstanding collateral balances of previously securitized loans for the dates presented:

The Company accounts for the difference between the carrying value and the total expected cash flows from these loans as an adjustment of the yield earned on the loans over their remaining lives. The discount is accreted to income over the period during which payments are probable of collection and are reasonably estimable. Additionally, the collectibility of previously securitized loans is evaluated over the remaining lives of the loans. An impairment charge on previously securitized loans would be provided through the Company’s provision for loan losses if the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans.  No such impairment charges were recorded for the three and six months ended June 30, 2007 and 2006, or for the year ending December 31, 2006.

As of June 30, 2007, the Company reported a book value of previously securitized loans of $10.3 million whereas the actual contractual outstanding balance of previously securitized loans at June 30, 2007 was $28.4 million. The difference (“the discount”) between the book value and the expected total cash flows from previously securitized loans is accreted into interest income over the life of the loans.

For the three months ended June 30, 2007 and 2006, the Company recognized $1.9 million and $2.5 million, respectively, of interest income from its previously securitized loans.  During the first six months of 2007 and 2006, the Company recognized $3.6 million and $5.2 million, respectively, of interest income from its previously securitized loans.

The Company utilizes interest rate floors to mitigate exposure to interest rate risk.  As of June 30, 2007, the Company has entered into eight interest rate floor contracts with a total notional amount of $600 million, seven of which (total notional amount of $500 million) are designated as cash flow hedges.  The objective of these interest rate floors is to protect the overall cash flows from the Company’s portfolio of $500 million of variable-rate loans outstanding from the risk of a decrease in those cash flows.

The notional amounts and estimated fair values of interest rate floor derivative positions outstanding at period end are presented in the following table. The estimated fair values of the interest rate floors on variable-rate loans are based on quoted market prices.

  Interest rate contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. These counterparties must have an investment grade credit rating and be approved by the Company’s Asset and Liability Committee.

For cash flow hedges, the effective portion of the gain or loss on the derivative hedging instrument is reported in other comprehensive income, while the ineffective portion (indicated by the excess of the cumulative change in the fair value of the derivative over that which is necessary to offset the cumulative change in expected future cash flows on the hedge transaction) is recorded in current earnings as other income or other expense.  The Company recognized the decrease in market value of $1.0 million, net of taxes, in Other Comprehensive Income for the six months ending June 30, 2007 on these derivative instruments.

During the second quarter of 2006, the Company redesignated an interest rate floor contract with a total notional amount of $100 million that had previously been accounted for as a freestanding derivative.   This interest rate floor has no fair value at June 30, 2007, matures in 11 months and has a strike rate of 6.00%.

The components of short-term borrowings are summarized below:

The Company formed a statutory business trust, City Holding Capital Trust (“the Capital Trust”), under the laws of Delaware.  The Capital Trust was created for the exclusive purpose of (i) issuing trust-preferred capital securities (“Capital Securities”), which represent preferred undivided beneficial interests in the assets of the trust, (ii) using the proceeds from the sale of the Capital Securities to acquire junior subordinated debentures (“Debentures”) issued by the Company, and (iii) engaging in only those activities necessary or incidental thereto.  The trust is considered a variable interest entity for which the Company is not the primary beneficiary.  Accordingly, the accounts of the trusts are not included in the Company’s consolidated financial statements.

The Capital Securities issued by the statutory business trust qualify as Tier 1 capital for the Company under the Federal Reserve Board guidelines.  In March 2005, the Federal Reserve Board issued a final rule that allows the inclusion of trust preferred securities issued by unconsolidated subsidiary trusts in Tier 1 capital, but with stricter limits.  Under ruling, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions.  The Company expects to continue to include all of its $16 million in trust preferred securities in Tier 1 capital.  The trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital.

Proceeds from stock option exercises totaled $0.2 million and $0.4 million during the six months ended June 30, 2007 and June 30, 2006, respectively. Shares issued in connection with stock option exercises are issued from available treasury shares. If no treasury shares are available, new shares are issued from available authorized shares. During the six months ended June 30, 2007 and June 30, 2006 all shares issued in connection with stock option exercises and restricted stock awards were issued from available treasury stock.

The fair value of the options is estimated at the date of grant using a Black-Scholes option-pricing model.   The following weighted average assumptions were used to estimate the fair value of options granted during the six months ended June 30, 2007:

The Company provides retirement benefits to its employees through the City Holding Company 401(k) Plan and Trust (“the 401(k) Plan”), which is intended to be compliant with Employee Retirement Income Security Act (ERISA) section 404(c). Any employee who has attained age 21 is eligible to participate beginning the first day of the month following employment. Unless specifically chosen otherwise, every employee is automatically enrolled in the 401(k) Plan and may make before-tax contributions of between 1% and 15% of eligible pay up to the dollar limit imposed by Internal Revenue Service regulations. The first 6% of an employee’s contribution is matched 50% by the Company. The employer matching contribution is invested according to the investment elections chosen by the employee. Employees are 100% vested in both employee and employer contributions and the earnings they generate. The Company’s total expense associated with the retirement benefit plan approximated $0.3 million for the six month periods ended June 30, 2007 and June 30, 2006.

The following table presents the components of the net periodic pension cost of the Defined Benefit Plan:

Loan commitments and standby and commercial letters of credit have credit risks essentially the same as that involved in extending loans to customers and are subject to the Company’s standard credit policies. Collateral is obtained based on management’s credit assessment of the customer. Management does not anticipate any material losses as a result of these commitments.

The following table sets forth the computation of total comprehensive income:

The following table sets forth the computation of basic and diluted earnings per share:

Options to purchase 47,500 shares of common stock at an exercise price of $39.34 and 43,750 shares of common stock at exercise prices between $36.25 and $36.90 per share were outstanding during the second quarter of 2007 and 2006, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would have been anti-dilutive.

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 clarifies the accounting and disclosure for uncertain tax positions by requiring that a tax position meet a "probable recognition threshold" for the benefit of the uncertain tax position to be recognized in the financial statements. A tax position that fails to meet the probable recognition threshold will result in either reduction of a current or deferred tax asset or receivable, or recording a current or deferred tax liability. FIN 48 also provides guidance on measurement, derecognition of tax benefits, classification, interim period accounting disclosure, and transition requirements in accounting for uncertain tax positions.  The cumulative effect of adopting FIN 48 was an increase in tax reserves and a decrease of $0.1 million to the January 1, 2007 retained earnings balance.  Upon adoption, the liability for income taxes associated with uncertain tax positions at January 1, 2007 was $1.6 million.  This amount, if recognized, would favorably affect the Company’s effective tax rate.   The Company does not expect that the amounts of unrecognized tax positions will change significantly within the next 12 months.

Interest and penalties related to income tax liabilities are included in income tax expense. The balance of accrued interest and penalties recorded in the Consolidated Balance Sheet at January 1, 2007 was $0.5 million.

The Company is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ended December 31, 2003 through 2006. The Company and its subsidiaries state income tax returns are open to audit under the statute of limitations for the years ended December 31, 2003 through 2006.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS No. 157).  SFAS No. 157 replaces various definitions of fair value in existing accounting literature with a single definition, establishes a framework for measuring fair value in generally accepted accounting principles, and requires additional disclosures about fair value measurements.  SFAS No. 157 does not expand the use of fair value to any new circumstances.  SFAS No. 157 is effective for fiscal years ending after November 15, 2007, and early application is encouraged.  The Company is currently evaluating SFAS No. 157 and has not determined the impact it will have on our financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.”  SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) is applicable on an instrument by instrument basis, with certain exceptions, (ii) is irrevocable (unless a new election date occurs), and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008.    The Company is currently evaluating SFAS No. 159 and has not determined the impact it will have on our financial statements.

The accounting policies of the Company conform with U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One to the audited financial statements included in the Company’s 2006 Annual Report to Shareholders. The information included in this Quarterly Report on Form 10-Q, including the Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with the financial statements and notes thereto included in the 2006 Annual Report of the Company.  Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, income taxes, and previously securitized loans to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available.

Pages 24 - 28 of this Quarterly Report on Form 10-Q provide management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the adequacy of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans.

Note B, beginning on page 8 of this Quarterly Report on Form 10-Q, and pages 28 and 29 provide management’s analysis of the Company’s previously securitized loans.  The carrying value of previously securitized loans is determined using assumptions with regard to loan prepayment and default rates. Using cash flow modeling techniques that incorporate these assumptions, the Company estimated total future cash collections expected to be received from these loans and determined the yield at which the resulting discount would be accreted into income.  If, upon periodic evaluation, the estimate of the total probable collections is increased or decreased but is still greater than the sum of the original carrying amount less subsequent collections plus the discount accreted to date, and it is probable that collection will occur, the amount of the discount to be accreted is adjusted accordingly and the amount of periodic accretion is adjusted over the remaining lives of the loans. If, upon periodic evaluation, the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans, an impairment charge would be provided through the Company’s provision for loan losses.  Please refer to Note B of Notes to Consolidated Financial Statements, on pages 8 - 9 for further discussion.

The Company reported consolidated net income of $25.5 million, or $1.48 per diluted common share, for the six months ended June 30, 2007, compared to $26.6 million, or $1.49 per diluted common share for the first six months of 2006. Return on average assets (“ROA”) was 2.02% and return on average equity (“ROE”) was 16.6% for the first six months of 2007, compared to 2.12% and 18.1%, respectively, for the first six months of 2006.

The Company’s net interest income for the first six months of 2007 decreased $3.0 million compared to the first six months of 2006 (see Net Interest Income). The Company recorded a provision for loan losses of $2.5 million for the first six months of 2007 while $1.7 million was recorded for the first six months of 2006 (see Allowance and Provision for Loan Losses).  As further discussed under the caption Non-Interest Income and Expense, non-interest income increased $2.2 million from the six months ended June 30, 2006, to the six months ended June 30, 2007.  During the first six months of 2007, the Company recognized a gain of $1.5 million from the sale of its existing merchant processing agreements.

The Company’s tax equivalent net interest income decreased $3.0 million, or 5.8%,  from the first six months of 2006 to the first six months of 2007 as increased yields on interest earning assets were more than offset by increases in the rates paid on interest-bearing liabilities.  Compared to the first six months of 2006, interest income increased $2.2 million while interest expenses paid on interest bearing liabilities increased $5.3 million due to rate increases.

Interest income on earning assets increased by $2.2 million, driven primarily by an increase in interest income on loans of $3.4 million despite a decrease of $1.6 million in interest income from previously securitized loans from the first six months of 2006.  The decrease in interest income from previously securitized loans was related to the continued decline in the average balance of these loans of 50.9% from $26.0 million for the six months ended June 30, 2006, to $12.8 million for the six months ended June 30, 2007.  However, this reduction in average outstanding balances was partially mitigated as the yield on these loans rose from an average of 40.4% for the first six months of 2006 to 57.0% for the first six months of 2007 (see Previously Securitized Loans section for further discussion).  In addition, interest income from loans was impacted by the sale of the Company’s credit card portfolio during the third quarter of 2006, which resulted in a decrease of $1.0 million in interest income from the first six months of 2006.  Interest income on all other loans (commercial, loans to depository institutions, residential, home equity, and consumer) increased by $5.9 million as the average yield on these loans increased by 28 basis points and the average balance on outstanding loans increased by $104.7 million (excluding previously securitized loans and credit card loans).

These increases were more than offset by an increase in interest expense on interest bearing liabilities of $5.3 million due primarily to a 60 basis point increase in the rates paid on interest bearing deposits from the first six months of 2006.  In addition, increases in average outstanding deposit balances of $86.8 million, or 5.4%, increased interest expense by $1.4 million.  The increase in rates and balances was primarily associated with time deposits that experienced an increase of 78 basis points while outstanding time deposit balances grew $74.2 million as compared to the first six months of 2006.

The net interest margin was 4.36% for the six months ended June 30, 2007 as compared to 4.64% for the six months ended June 30, 2006.  The decline in the net interest margin can primarily be attributed to lower interest income from previously securitized loans and the sale of the retail credit card portfolio during the third quarter of 2006.  Excluding these items, the Company’s net interest margin decreased 16 basis points from 4.27% during the first six months of 2006 to 4.11% for the first six months of 2007.  This compression is due to increased rates paid on interest bearing liabilities, primarily time deposits.

The Company’s tax equivalent net interest income decreased $1.6 million, or 6.1%,  from the second quarter of 2006 to the second quarter of 2007 as increased yields on interest earning assets were more than offset by increases in the rates paid on interest-bearing liabilities.  Compared to the second quarter of 2006, interest income increased $0.5 million while interest expenses paid on interest bearing liabilities increased $2.1 million due to rate increases.

Interest income on earning assets increased by $0.5 million, driven primarily by an increase in interest income on loans of $1.5 million, despite a decrease of $0.7 million in interest income from previously securitized loans from the second quarter of 2006.  The decrease in interest income from previously securitized loans was related to the continued decline in the average balance of these loans of 53.4% from $24.0 million for the quarter ended June 30, 2006, to $11.2 million for the quarter ended June 30, 2007.  However, this reduction in average outstanding balances was partially mitigated as the yield on these loans rose from an average of 41.9% for the second quarter of 2006 to 66.4% for the second quarter of 2007 (see Previously Securitized Loans section for further discussion). The yield for the first quarter of 2007 was 49.5%.  In addition, interest income from loans was impacted by the sale of the Company’s credit card portfolio during the third quarter of 2006, which resulted in a decrease of $0.5 million in interest income from the second quarter of 2006.  Interest income on all other loans (commercial, loans to depository institutions, residential, home equity, and consumer) increased by $2.6 million as the average yield on these loans increased by 18 basis points and the average balance on outstanding loans increased by $106.5 million (excluding previously securitized loans and credit card loans).

These increases were partially offset by an increase in interest expense on interest bearing liabilities of $2.5 million due primarily to a 44 basis point increase in the rates paid on interest bearing deposits from the second quarter of 2006.  In addition, increases in average outstanding deposit balances of $73 million, or 4.5%, increased interest expense by $0.6 million.  The increase in rates and balances was primarily associated with time deposits that experienced an increase of 66 basis points while outstanding time deposit balances grew $57 million as compared to the second quarter of 2006.

The net interest margin was 4.32% for the quarter ended June 30, 2007 as compared to 4.58% for the quarter ended June 30, 2006.  The decline in the net interest margin can partially be attributed to lower interest income from previously securitized loans and the sale of the retail credit card portfolio during the third quarter of 2006.  Excluding these items, the Company’s net interest margin decreased 18 basis points from 4.23% during the second quarter of 2006 to 4.05% for the second quarter of 2007.  This compression is due to an increase in the rates paid on total interest bearing liabilities, and reflects an increase in the cost of time deposits.