UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For The Quarterly Period Ended September 30, 2005
OR
For The Transition Period From To .
Commission File number 0-11733
CITY HOLDING COMPANY
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification Number)
(304) 769-1100
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.
Common stock, $2.50 Par Value – 18,078,551 shares as of October 31, 2005.
FORWARD-LOOKING STATEMENTS
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 loan loss provision 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 on previously securitized loans that would result in impairment losses or lower the yield on such loans; (4) the Company could have adverse legal actions of a material nature; (5) the Company may face competitive loss of customers; (6) the Company may be unable to manage its expense levels; (7) the Company may have difficulty retaining key employees; (8) 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; (9) changes in general economic conditions and increased competition could adversely affect the Company’s operating results; (10) 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 (11) 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.
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Index
City Holding Company and Subsidiaries
Pages
Item 1.
Financial Statements (Unaudited).
Consolidated Balance Sheets – September 30, 2005 and December 31, 2004.
Consolidated Statements of Income – Three months ended September 30, 2005 and 2004 and Nine months ended September 30, 2005 and 2004.
Consolidated Statements of Changes in Stockholders’ Equity – Nine months ended September 30, 2005 and 2004.
Consolidated Statements of Cash Flows – Nine months ended September 30, 2005 and 2004.
Notes to Consolidated Financial Statements – September 30, 2005.
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 3.
Quantitative and Qualitative Disclosures about Market Risk.
Item 4.
Controls and Procedures.
Legal Proceedings.
Unregistered Sales of Equity Securities and Use of Proceeds.
Defaults Upon Senior Securities.
Submission of Matters to a Vote of Security Holders.
Item 5.
Other Information.
Item 6.
Exhibits.
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PART I, ITEM 1 – FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
CITY HOLDINGCOMPANY AND SUBSIDIARIES
(in thousands)
Assets
Cash and due from banks
Interest-bearing deposits in depository institutions
Cash and Cash Equivalents
Securities available for sale, at fair value
Securities held-to-maturity, at amortized cost (approximate fair value at September 30, 2005 and December 31, 2004 - $60,846 and $64,476)
Total Securities
Loans:
Residential real estate
Home equity
Commercial real estate
Other commercial
Installment
Indirect
Credit card
Previously securitized loans
Gross loans
Allowance for loan losses
Net Loans
Bank owned life insurance
Premises and equipment
Accrued interest receivable
Net deferred tax asset
Intangible assets
Other assets
Total Assets
Liabilities
Deposits:
Noninterest-bearing
Interest-bearing:
Demand deposits
Savings deposits
Time deposits
Total Deposits
Short-term borrowings
Long-term debt
Other liabilities
Total Liabilities
Shareholders’ Equity
Preferred stock, par value $25 per share: 500,000 shares authorized; none issued
Common stock, par value $2.50 per share: 50,000,000 shares authorized; 18,499,282 and 16,919,248 shares issued at September 30, 2005 and December 31, 2004, respectively, less 329,931 and 331,191 shares, respectively, in treasury
Capital surplus
Retained earnings
Cost of common stock in treasury
Accumulated other comprehensive income:
Unrealized (loss) gain on securities available-for-sale
Unrealized (loss) on interest rate floors
Underfunded pension liability
Total Accumulated Other Comprehensive Income
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
CITY HOLDING COMPANY AND SUBSIDIARIES
(in thousands, except earnings per share data)
Interest Income
Interest and fees on loans
Interest on investment securities:
Taxable
Tax-exempt
Interest on retained interests
Interest on deposits in depository institutions
Interest on federal funds sold
Total Interest Income
Interest Expense
Interest on deposits
Interest on short-term borrowings
Interest on long-term debt
Total Interest Expense
Net Interest Income
Provision for loan losses
Net Interest Income After Provision for Loan Losses
Non-Interest Income
Investment securities gains
Service charges
Insurance commissions
Trust fee income
Mortgage banking income
Net proceeds from legal settlement
Other income
Total Non-Interest Income
Non-Interest Expense
Salaries and employee benefits
Occupancy and equipment
Depreciation
Professional fees and litigation expense
Postage, delivery, and statement mailings
Advertising
Telecommunications
Insurance and regulatory
Office supplies
Repossessed asset (gains) losses, net of expenses
Loss on early extinguishment of debt
Other expenses
Total Non-Interest Expense
Income Before Income Taxes
Income tax expense
Net Income
Basic earnings per common share
Diluted earnings per common share
Dividends declared per common share
Average common shares outstanding:
Basic
Diluted
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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)
NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004
Balances at December 31, 2003
Comprehensive income:
Net income
Changes in other comprehensive income, net of deferred income taxes of $150:
Net unrealized loss on available-for-sale securities of $376, net of reclassification adjustment for gains included in net income of $1,115
Total comprehensive income
Cash dividends declared ($0.66/share)
Exercise of 114,403 stock options
Purchase of 197,040 shares for treasury
Balances at September 30, 2004
Balances at December 31, 2004
Changes in other comprehensive income, net of deferred income taxes of $1,975:
Net unrealized loss on available-for-sale securities of $4,032, net of reclassification adjustment for gains included in net income of $26
Net unrealized loss on interest rate floors of $905, net of reclassification adjustment for net losses included in net income of $138
Cash dividends declared ($0.75 per share)
Issuance of 1,580,034 shares for acquisition of Classic Bancshares, net 108,173 shares owned and transferred to treasury
Issuance of 18,300 stock awards shares
Exercise of 262,709 stock options
Purchase of 173,876 shares for treasury
Balances at September 30, 2005
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CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net amortization
Provision for depreciation
Deferred income tax expense
Periodic pension cost
(Gain) loss on sales of premises and equipment
Realized investment securities gains
Increase in retained interests
Proceeds from bank owned life insurance
Increase in value of bank owned life insurance
(Increase) decrease in accrued interest receivable
Increase in other assets
Decrease in other liabilities
Net Cash Provided by Operating Activities
Investing Activities
Proceeds from sales of available for sale securities
Proceeds from maturities and calls of available for sale securities
Purchases of available for sale securities
Proceeds from sale of money market and mutual fund available for sale securities
Purchases of money market and mutual fund available for sale securities
Purchases of held-to-maturity securities
Proceeds from maturities and calls of held-to-maturity securities
Net increase in loans
Redemption of retained interests
Sales of premises and equipment
Purchases of premises and equipment
Acquisition, net cash received
Net Cash Provided by (Used in) Investing Activities
Financing Activities
Net decrease in noninterest-bearing deposits
Net (decrease) increase in interest-bearing deposits
Net increase (decrease) in short-term borrowings
Proceeds from long term debt
Repayment of long-term debt
Purchases of treasury stock
Exercise of stock options and issuance of stock awards
Cash dividends paid
Net Cash Used in Financing Activities
Increase (Decrease) in Cash and Cash Equivalents
Cash and cash equivalents at beginning of period
Cash and Cash Equivalents at End of Period
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2005
NOTE A – BASIS OF PRESENTATION
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 nine months ended September 30, 2005 are not necessarily indicative of the results of operations that can be expected for the year ending December 31, 2005. 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, 2004 has been extracted from audited financial statements included in the Company’s 2004 Annual Report to Stockholders. Certain information and footnote disclosures normally included in 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 2004 Annual Report of the Company.
Certain amounts in the 2004 financial statements have been reclassified to conform to the 2005 presentation. Such reclassifications had no impact on net income or shareholders’ equity.
NOTE B –RETAINED INTERESTS AND PREVIOUSLY SECURITIZED LOANS
Between 1997 and 1999, the Company originated and securitized $760 million in 125% loan to value junior-lien underlying mortgages in six separate pools. The Company had a retained interest in the residual cash flows associated with these underlying mortgages after satisfying priority claims. Principal amounts owed to investors in the securitizations were evidenced by Notes that were subject to redemption under certain circumstances. Once the Notes were redeemed, the Company became the beneficial owner of the mortgage loans and recorded the loans as “Previously Securitized Loans” within the loan portfolio. The Company exercised its early redemption option with respect to four of the trusts during 2003 and the remaining two trusts during 2004. As a result, carrying balances for “Retained Interests” became classified as “Previously Securitized Loans”. The table below summarizes information regarding delinquencies, net credit losses, and outstanding collateral balances of previously securitized loans for the dates presented:
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As of and for the
Nine Months EndedSeptember 30,
( in thousands)
Previously Securitized Loans:
Total principal amount of loans outstanding
Discount
Net book value
Principal amount of loans between 30 and 89 days past due
Principal amount of loans 90 days and above past due
Net credit (recoveries) losses during the period
In accordance with Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, issued by the Accounting Standards Executive Committee, the Company is accounting for the difference between the carrying value and the outstanding balance of 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 and allowance for loan losses if the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans.
As the Company redeemed the outstanding Notes from its securitizations, no gain or loss was recognized in the Company’s financial statements and the remaining mortgage loans were recorded in the Company’s loan portfolio at carrying value. Because the book value of the mortgage loans incorporates assumptions for expected prepayment and default rates, the book value of the loans is generally less than the contractual outstanding balance of the mortgage loans. As of September 30, 2005, the Company reported a book value of previously securitized loans of $35.6 million whereas the actual contractual outstanding balance of previously securitized loans at September 30, 2005, was $53.3 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.
During the first nine months of 2005 and 2004, the Company recognized $8.8 million and $10.9 million, respectively, of interest income from its previously securitized loans. This interest income was comprised of $7.7 million and $9.7 million, respectively, of interest and $1.1 million and $1.2 million, respectively, of discount accretion. The Company also earned $0.8 million of interest income on its retained interests asset during the nine months ended September 30, 2004.
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NOTE C –DERIVATIVE INSTRUMENTS
The Company enters into derivative transactions principally to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. Under the guidelines of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, all derivative instruments are required to be carried at fair value on the balance sheet. SFAS No. 133 provides special hedge accounting provisions, which permit the change in the fair value of the hedged item related to the risk being hedged to be recognized in earnings in the same period and in the same income statement line as the change in the fair value of the derivative.
Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under SFAS No. 133. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking each hedge transaction.
Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from other comprehensive income to the income statement in the period or periods the hedged forecasted transaction affects earnings. The Company has not entered into any fair value hedges as of September 30, 2005.
For the Company’s cash flow hedges, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement. At the hedge’s inception and at least quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instruments have been highly effective in offsetting changes in the fair values or cash flows of the hedged items and whether they are expected to be highly effective in the future. If it is determined a derivative instrument has not been or will not continue to be highly effective as a hedge, hedge accounting is discontinued.
NOTE D – SHORT-TERM BORROWINGS
The components of short-term borrowings are summarized below:
Security repurchase agreements
Short-term FHLB advances
Total short-term borrowings
Securities sold under agreement to repurchase were sold to corporate and government customers as an alternative to available deposit products. The underlying securities included in repurchase agreements remain under the Company’s control during the effective period of the agreements.
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NOTE E – LONG-TERM DEBT
The components of long-term debt are summarized below:
(dollars in thousands)
FHLB Advances
Junior subordinated debentures owed to City Holding Capital Trust
Total long-term debt
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 trusts, (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. On March 1, 2005, the Federal Reserve Board issued a final rule that retains the inclusion of trust preferred securities in Tier 1 of capital of bank holding companies. After a five year transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements, will be limited to 25% of Tier 1 capital elements, net of goodwill less associated deferred tax liability. Amounts of restricted core capital elements in excess of this limit generally may be included in Tier 2 capital.
NOTE F – EMPLOYEE BENEFIT PLANS
Employees, directors and individuals who provide service to the Company (collectively “Plan Participants”) are eligible to participate in the Company’s 2003 Stock Incentive Plan (“the Plan”). Pursuant to the terms of the Plan, the Compensation Committee of the Board of Directors, or its delegate, may, from time-to-time, grant stock options, stock appreciation rights (“SARs”), or stock awards to Plan Participants. A maximum of 1,000,000 shares of the Company’s common stock may be issued upon the exercise of stock options and SARs and stock awards, but no more than 350,000 shares of common stock may be issued as stock awards. These limitations may be adjusted in the event of a change in the number of outstanding shares of common stock by reason of a stock dividend, stock split, or other similar event. Specific terms of options and SARs awarded, including vesting periods, exercise prices, and expiration dates are determined at the date of grant and are evidenced by agreements between the Company and the awardee.
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The Company has elected to account for its employee stock options using the intrinsic value method. Because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
The alternative fair value method of accounting for stock-based compensation (see Recent Accounting Pronouncements) requires the use of option valuation models, such as the Black-Scholes option-pricing model for use in valuing employee stock options.
Pro forma information regarding net income and earnings per share determined as if the Company had accounted for its employee stock options under the fair value method is presented below. The fair value for the options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
Risk-free interest rate
Expected dividend yield
Volatility factor
Expected life of option
For purposes of pro forma disclosures, the estimated fair value of options is amortized to expense over the options’ vesting period. Pro forma net income, basic earnings per share, and diluted earnings per share for the three and nine months ended September 30, 2005 and 2004 were:
Net income, as reported
Pro forma stock-based employee compensation expense, net of tax
Net income, pro forma
Basic earnings per share, as reported
Basic earnings per share, pro forma
Diluted earnings per share, as reported
Diluted earnings per share, pro forma
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Stock-based compensation expense associated with stock awards, included in salaries and employee benefits, was $0.1 million and $0.1 million for the nine and three month period ended September 30, 2005, respectively. There was no expense associated with stock awards for the 2004 reporting period.
A summary of the Company’s stock option activity and related information is presented below for the nine months ended September 30:
Outstanding at January 1
Granted
Exercised
Forfeited
Outstanding at September 30
Additional information regarding stock options outstanding and exercisable at September 30, 2005, is provided in the following table:
Ranges of Exercise Prices
$13.30
$28.00 - $35.36
In addition to stock options, the Company also grants restricted stock awards to certain officers and employees. The Company records deferred compensation in stockholders’ equity with respect to such awards in an amount equal to the fair market value of the common stock covered by each award on the date of grant. The restricted shares awarded become fully vested after various periods of continued employment from the respective dates of grant. The Company becomes entitled to an income tax deduction in an amount equal to the taxable income reported by the holders of the restricted shares when the restrictions are released and the shares are issued. The deferred compensation cost reflected in stockholders’ equity is being amortized as compensation expense over the respective vesting periods using the straight-line method. Restricted shares are forfeited if officers and employees terminate prior to the lapsing of restrictions. The Company records forfeitures of restricted stock as treasury share repurchases and any compensation cost previously recognized is reversed in the period of forfeiture.
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
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generate. The Company’s total expense associated with the retirement benefit plan approximated $0.4 million for each of the nine month periods ended September 30, 2005 and 2004, and approximated $0.1 million for each of the three month periods ended September 30, 2005 and 2004.
The Company also maintains a defined benefit pension plan (“the Defined Benefit Plan”) that covers approximately 300 current and former employees. The Defined Benefit Plan was frozen in 1999 subsequent to the Company’s acquisition of the plan sponsor. The Defined Benefit Plan maintains an October 31 year-end for purposes of computing its benefit obligations. During the first nine months of 2005 and 2004, the Company made contributions to the Defined Benefit Plan approximating $0.1 million and $0.3 million, respectively.
The following table presents the components of the net periodic pension cost of the Defined Benefit Plan:
Components of net periodic cost:
Interest cost
Expected return on plan assets
Net amortization and deferral
Net Periodic Pension Cost
NOTE G – COMMITMENTS AND CONTINGENCIES
The Company is a party to certain financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. The Company has entered into agreements with its customers to extend credit or provide a conditional commitment to provide payment on drafts presented in accordance with the terms of the underlying credit documents. The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment. Overdraft protection commitments, which are included with other commitments below, are uncollateralized and are paid at the Company’s discretion. Conditional commitments generally include standby and commercial letters of credit. Standby letters of credit represent an obligation of the Company to a designated third party contingent upon the failure of a customer of the Company to perform under the terms of the underlying contract between the customer and the third party. Commercial letters of credit are issued specifically to facilitate trade or commerce. Under the terms of a commercial letter of credit, drafts will be drawn when the underlying transaction is consummated, as intended, between the customer and a third party. The funded portion of these financial instruments is reflected in the Company’s balance sheet, while the unfunded portion of these commitments is not reflected in the balance sheet. The table below presents a summary of the contractual obligations of the Company resulting from significant commitments:
Commitments to extend credit:
Home equity lines
Credit card lines
Other commitments
Standby letters of credit
Commercial letters of credit
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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.
NOTE H – TOTAL COMPREHENSIVE INCOME
The following table sets forth the computation of total comprehensive income:
Unrealized security (losses) gains arising during the period
Reclassification adjustment for gains included in income
Unrealized loss on interest rate floors
Reclassification adjustment for net losses included in income
Other comprehensive income before income taxes
Tax effect
NOTE I – EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
(in thousands, except per share data)
Average shares outstanding
Effect of dilutive securities:
Employee stock options
Shares for diluted earnings per share
Basic earnings per share
Diluted earnings per share
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NOTE J – ACQUISITIONS
On May 20, 2005, City completed the acquisition of Classic Bancshares (“Classic”) and the merger of Classic’s subsidiary, Classic Bank, into City National Bank. City and Classic had entered into a definitive agreement and plan of merger on December 29, 2004. Classic operated 10 full-service branches located in Eastern Kentucky and Southeastern Ohio. The primary reason for the merger with Classic was for City to expand its presence in the Huntington/Ashland WV-KY-OH Metropolitan Statistical Area (“MSA”). With the acquisition of Classic, City is now the largest commercial banking franchise in the Huntington/Ashland WV-KY-OH MSA. On May 20, 2005, Classic had total assets of $338 million, net loans of $254 million, deposits of $252 million, and $38 million of shareholders’ equity. The acquisition was accounted for using the purchase accounting method and the results of operations of Classic are included in City’s consolidated statement of income from the date of acquisition forward.
The aggregate purchase price for the acquisition was approximately $81 million and was consummated by the exchange of a combination of City’s common stock and cash for Classic’s common stock. Shareholders of Classic’s common stock received 0.9624 shares of City’s common stock and $11.08 in cash for each share of Classic common stock owned by them. The purchase was funded through the issuance of 1,580,034 shares of City newly issued common shares and cash consideration of $18.2 million from City’s available cash.
City also paid $3.3 million for Classic’s outstanding stock options and incurred $1.9 million in direct costs associated with the merger. Included in the direct merger costs were $0.9 million of involuntary employee termination costs, $0.9 million of legal, accounting advisory and conversion costs, and $0.1 million of other direct merger related costs.
The cost to acquire Classic has been allocated to the identifiable tangible and intangible assets acquired and liabilities assumed based upon preliminary estimated fair values. The allocation of the purchase price is preliminary and is subject to changes in the estimated fair values of assets acquired and liabilities assumed. The excess of the purchase price over the estimated fair values of assets acquired and liabilities assumed ($49.4 million) was assigned to goodwill. In connection with the preliminary purchase price allocation, City also assigned approximately $4.9 million to intangible assets including $4.4 million to deposit base intangibles. Deposit base intangibles are being amortized over their estimated remaining life of 10 years on an accelerated basis. Goodwill arising from the transaction is not subject to amortization and is not deductible for tax purposes. Goodwill will be evaluated annually for possible impairment.
Pro forma information regarding the acquisition has not been presented as the acquisition is not deemed to be significant, and pro forma results assuming that the acquisition had occurred at the beginning of 2005 and 2004 would not be materially different than the results reported herein.
NOTE K – RECENT ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock Issued for Employees.” SFAS No. 123R requires that all share-based payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period. On April 15, 2005, the Securities and Exchange Commission (“SEC”) announced that it would permit companies to implement SFAS No. 123R at the
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beginning of their next fiscal year (January 1, 2006 for the Company) instead of their next reporting period beginning after June 15, 2005, as required by SFAS No. 123R. The Company expects to transition to SFAS No. 123R using the “modified prospective application.” Under the “modified prospective application,” compensation costs will be recognized in the financial statements for all new share-based payments granted after January 1, 2006. Additionally, the Company will recognize compensation costs for the portion of previously granted awards that are outstanding as of January 1, 2006 for which the requisite service has not been rendered (“nonvested awards”) over the remaining requisite service period of the awards. The compensation expense to be recognized for the nonvested awards will be based on the fair value of the awards at their grant date. The Company does not expect that the recognition of compensation costs for unvested options upon the date of adoption will be materially different from the pro forma information shown under Note F, “Employee Benefit Plans.” Compensation expense for share-based awards granted after the date of adoption will depend on the number of awards issued and the fair value of that award on the grant date.
In June 2005, the FASB issued FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other Than Temporary Impairment and Its Application to Certain Investments”, which clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. FSP FAS 115-1 will be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. The Company does not anticipate that FSP FAS 115-1 will materially impact the Company’s financial condition or results of operations. The FASB recently said that no further guidance on other-than temporary impairment would be forthcoming.
In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which addresses the accounting for differences between the contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality. SOP 03-3 requires that the excess of expected cash flows over contractual cash flows generally to be recognized prospectively through adjustment to the yield over the remaining lives of the loans. SOP 03-3 requires that decreases in cash flows expected to be collected be recognized as an impairment loss in the period the impairment is determined. Effective January 1, 2005, the Company adopted the provisions of SOP 03-3 as required.
In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements be termed a “restatement.” The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not anticipate this revision will have a material effect on its financial statements.
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In July 2005, the FASB issued an Exposure Draft of a proposed Interpretation, “Accounting for Uncertain Tax Positions”. The proposed Interpretation clarifies the accounting for uncertain tax positions in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. The proposed Interpretation requires 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. The proposed Interpretation also provides guidance on measurement, derecognition of tax benefits, classification, interim period accounting disclosure, and transition requirements in accounting for uncertain tax positions. The proposed Interpretation has a 60-day comment period and is expected to be effective for all companies as of the first fiscal year ending after December 15, 2005. The Company is assessing the impact of adopting the new pronouncement and is currently unable to estimate its impact, if any, on the Company’s consolidated financial statements.
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ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
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 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 2004 Annual Report to Stockholders. 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 2004 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 and the accounting for its 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 26 - 30 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 30 and 31 provide management’s analysis of the Company’s previously securitized loans. Amounts reported in the Consolidated Balance Sheets as “previously securitized loans” represent the carrying value of loans beneficially owned by the Company as a result of having fully redeemed the obligations owed to investors (“Notes”) in certain of the Company’s securitization transactions. 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. Effective January 1, 2005, the Company adopted Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3), issued by the Accounting Standards Executive Committee. This pronouncement did not change the accounting for the difference between the carrying value and the outstanding balance of these loans as an adjustment of the yield earned on these 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
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collectibility of previously securitized loans is evaluated over the remaining lives of the loans. In accordance with SOP 03-3, an impairment charge on previously securitized loans would be provided through the Company’s provision and allowance for loan losses if the discounted present value of estimated future cash flows decline below the recorded value of previously securitized loans.
FINANCIAL SUMMARY
Nine Months Ended September 30, 2005 vs. 2004
The Company reported consolidated net income of $37.2 million, or $2.12 per diluted common share, for the nine months ended September 30, 2005, compared to $35.3 million, or $2.09 per diluted common share for the nine months ended September 30, 2004. The nine months ended September 30, 2004 included income of $3.2 million net of expenses and taxes, or $0.19 per diluted share, recognized in conjunction with the settlement of a derivative action brought against certain current and former directors and former executive officers of City Holding Company and City National Bank. Also, as previously noted, City completed its acquisition of Classic Bancshares during the second quarter of 2005. Return on average assets (“ROA”) was 2.09% and return on average equity (“ROE”) was 19.50% for the first nine months of 2005, compared to 2.12% and 23.12%, respectively, for the first nine months of 2004.
Net interest income increased $6.1 million from $65.4 million for the nine months ended September 30, 2004, to $71.5 million for the nine months ended September 30, 2005. Net of investment securities gains and legal settlement proceeds, non-interest income increased $5.0 million, or 15.7%, during the first nine months of 2005, as compared to the first nine months of 2004. This increase was primarily due to increased service charge income of $4.7 million, or 19.3%, from $23.9 million to $28.6 million for the nine months ended September 30, 2004 and 2005, respectively. Non-interest expense increased $1.6 million during the first nine months of 2005, primarily as a result of additional non-interest expenses from the Classic acquisition of $2.0 million. These were partially offset by lower legal expenses for the nine months ended September 30, 2005 as additional legal expenses of $0.9 million were incurred during the nine months ended September 30, 2004 in association with the derivative action. The Company recorded a provision for loan losses of $0.6 million for the nine months ended September 30, 2005 while no provision for loan losses was recorded during the nine months ended September 30, 2004 (see Allowance and Provision for Loan Losses).
Three Months Ended September 30, 2005 vs. 2004
The Company reported consolidated net income of $13.2 million, or $0.72 per diluted common share, for the three months ended September 30, 2005, compared to $11.0 million, or $0.65 per diluted common share for the third quarter of 2004. Return on average assets (“ROA”) was 2.09% and return on average equity (“ROE”) was 18.23% for the third quarter of 2005, compared to 1.98% and 21.41%, respectively, for the third quarter of 2004.
The Company’s net interest income increased $4.0 million when comparing the third quarter of 2004 to the third quarter of 2005 (see Net Interest Income). As further discussed under the caption Non-Interest Income and Expense, the Company experienced continued growth in non-interest income in 2005, as compared to 2004, as service charge revenues earned on depository relationships increased $2.0 million, or 23.6%, from $8.4 million in the third quarter of 2004 to $10.4 million in 2005. Non-interest expenses increased from $15.8 million in the third quarter of 2004 to $17.9 million in the third quarter of 2005 due to increases in non-interest expenses from the Classic acquisition ($1.5 million); increased advertising expenses ($0.3 million); and increases in other expenses ($0.4 million).
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NET INTEREST INCOME
On a tax equivalent basis, net interest income increased $6.2 million, or 9.3%, from $66.1 million in the first nine months of 2004 to $72.3 million in the first nine months of 2005. This increase was primarily due to the Classic acquisition and from increased interest income from the Company’s traditional loan portfolio (excluding previously securitized loans). The Classic acquisition increased interest income by $6.5 million during the first nine months of 2005. Interest income from traditional loan products increased $6.6 million, or 12.3%, when comparing the nine months ended September 30, 2004 to the nine months ended September 30, 2005. This was due to an increase in the average balances outstanding of these loans of $59.6 million, or 4.8%, and increased yields on such loans of approximately 42 basis points. The yield improved as a result of increases by the Federal Reserve in the Federal Funds rate and the Company’s positioning of its balance sheet to benefit from such rising rates.
These increases were partially offset by decreased income associated with previously securitized loans and additional interest expense. Decreasing balances of previously securitized loans and retained interests with high yields reduced the amount of interest income reported. Average balances of previously securitized loans and retained interests decreased from $89.2 million for the nine months ended September 30, 2004 to $46.2 million for the nine months ended September 30, 2005. As a result of this decrease of $43.0 million, interest income from these loan types decreased $5.8 million from the nine months ended September 30, 2004 to the nine months ended September 30, 2005. This decrease was partially mitigated as the yield on previously securitized loans increased from 17.21% for the nine months ended September 30, 2004 to 25.54% for the nine months ended September 30, 2005 as a result of lower default rates and balances prepaying faster than expected (see Previously Securitized Loans). As a result of the yield increase, interest income from previously securitized loans increased $2.9 million when comparing the nine months ended September 30, 2004 to the nine months ended September 30, 2005. Additionally, as a result of the Classic acquisition and the increasing interest rate environment, interest expense increased $3.6 million when comparing the nine months ended September 30, 2004 to the nine months ended September 30, 2005.
The net interest margin for the first nine months of 2005 of 4.46% represented a 16 basis point increase from the first nine months of 2004’s net interest margin of 4.30%. In order to offset the decreasing balances of high yielding previously securitized loans and resultant lower levels of interest income from these assets, the Company positioned its balance sheet to benefit from rising interest rates. Since September 2004, the Federal funds rate has increased 275 basis points from 1.00% to 3.75% in September 2005. To manage its interest rate risk, the Company has focused on the origination of variable rate lending in its traditional lending areas of residential real estate, home equity and commercial real estate loan portfolios. Excluding the impact of previously securitized loans, retained interests and the Classic acquisition, the Company’s net interest margin increased 48 basis points, or $3.8 million, for the nine months ended September 30, 2004 when compared to the nine months ended September 30, 2005.
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During the third quarter of 2005, the Company recorded tax equivalent net interest income of $25.9 million as compared to $21.9 million during the third quarter of 2004. This increase was primarily due the Classic acquisition and increased interest income from the Company’s traditional loan portfolio. The Classic acquisition increased interest income by $4.5 million during the three months ended September 30, 2005. Interest income from the Company’s traditional loan portfolio increased $3.1 million, or 17.1%, for the third quarter of 2005 as compared to the third quarter of 2004. This was due to an increase in the average balances outstanding of $47.3 million, or 3.7%, and increased yields on such loans of approximately 65 basis points. The yield improved as a result of increases by the Federal Reserve in the Federal Funds rate and the Company’s positioning of its balance sheet to benefit from such rising rates by emphasizing variable rate loan products as previously discussed.
These increases were partially offset by decreased income associated with previously securitized loans and increased interest expense. Decreasing balances of previously securitized loans with high yields reduced the amount of interest income reported. Average balances of previously securitized loans decreased from $78.9 million for the quarter ended September 30, 2004 to $38.4 million for the quarter ended September 30, 2005. As a result of this decrease of $40.5 million, interest income from previously securitized loans declined $1.7 million from the quarter ended September 30, 2004 to the quarter ended September 30, 2005. This decrease was partially mitigated as the yield on previously securitized loans increased from 16.83% for the three months ended September 30, 2004 to 30.14% for the three months ended September 30, 2005 as a result of lower default rates and balances prepaying faster than expected (see Previously Securitized Loans). As a result of the yield increase, interest income from previously securitized loans increased $1.3 million from the three months ended September 30, 2004 to the three months ended September 30, 2005. Additionally, as a result of the Classic acquisition and the increasing interest rate environment, interest expense increased $2.3 million for the three months ended September 30, 2005 when compared to the three months ended September 30, 2004.
The net interest margin for the second quarter of 2005 of 4.51% represented a 26 basis point increase from the second quarter of 2004’s net interest margin of 4.25% and represented an 9 basis point increase from the net interest margin of 4.42% for the linked quarter ended June 30, 2005. In order to offset the decreasing balances of high yielding previously securitized loans and resultant lower levels of interest income from these assets, the Company positioned its balance sheet to benefit from rising interest rates by emphasizing variable rate loan products. Excluding the impact of previously securitized loans, retained interests and the Classic acquisition, the Company’s net interest margin increased 22 basis points, or $0.7 million, when comparing the quarter ended September 30, 2005 to the quarter ended September 30, 2004.
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TABLE ONE
AVERAGE BALANCE SHEETS AND NET INTEREST INCOME
Loan portfolio (1):
Loans to depository institutions
Total loans
Securities:
Tax-exempt (2)
Total securities
Retained interests in securitized loans
Deposits in depository institutions
Federal funds sold
Total interest-earning assets
Bank premises and equipment
Less: Allowance for loan losses
Total assets
Interest-bearing demand deposits
Total interest-bearing liabilities
Noninterest-bearing demand deposits
Stockholders’ equity
Total liabilities and stockholders’ equity
Net interest income
Net yield on earning assets
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TABLE TWO
RATE VOLUME ANALYSIS OF CHANGES IN INTEREST INCOME AND INTERESTEXPENSE
Interest-earning assets:
Loan portfolio
Tax-exempt (1)
Interest-bearing liabilities:
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TABLE THREE
Less: allowance for loan losses
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TABLE FOUR
ALLOWANCE AND PROVISION FOR LOAN LOSSES
Management systematically monitors the loan portfolio and the adequacy of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses inherent in the portfolio. Management assesses the risk in each loan type based on historical trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits are selected throughout the year for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the adequacy of the ALLL. Due to the nature of commercial lending, evaluation of the adequacy of the ALLL as it relates to these loan types is often based more upon specific credit reviews, with consideration given to the potential impairment of certain credits and historical charge-off percentages, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the ALLL allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for current economic conditions and other inherent risk factors.
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In evaluating the adequacy of the ALLL, management considers both quantitative and qualitative factors. Quantitative factors include actual repayment characteristics and loan performance, cash flow analyses, and estimated fair values of underlying collateral. Qualitative factors generally include overall trends within the portfolio, composition of the portfolio, changes in pricing or underwriting, seasoning of the portfolio, and general economic conditions.
The ALLL not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the adequacy of the ALLL. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss percentages are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends.
Determination of the ALLL is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its evaluation model to ensure that adequate provision has been made for risk in the total loan portfolio.
As a result of the Company’s quarterly analysis of the adequacy of the ALLL, the Company recorded a provision for loan losses of $0.6 million in the third quarter of 2005. This is the first quarter since the second quarter of 2002 that the Company’s quarterly analysis of the adequacy of the ALLL has resulted in a provision for loan losses. During the last three years, management has implemented a number of strategic initiatives to strengthen the loan portfolio including tightening credit standards, changing the overall mix of the portfolio to include a higher proportion of real estate secured loans, and identifying and charging off or resolving problem loans. As a result of these initiatives, the quality of the Company’s loan portfolio has increased significantly as evidenced by the improvement in its ratio of non-performing assets to total loans and other real estate owned from 1.38% at September 30, 2002 to 0.23% at September 30, 2005. As the Company’s asset quality has improved, the required level of the ALLL has decreased. The provision for loan losses recorded during the third quarter of 2005 was a result of an increase in loss trends for overdraft deposit accounts and credit card loans and growth in the outstanding balances of commercial real estate loans during the quarter. Increased losses in the overdraft deposit accounts and credit card loans categories are consistent with trends being experienced by banks nationally during 2005 and appear to have been impacted by the new bankruptcy laws that became effective on October 17, 2005. Additionally, the Company has continued to experience growth in commercial real estate loans, which have increased average balances by $91 million from September 30, 2004 to September 30, 2005. While these trends have required the Company to record a provision during the third quarter, the amount of provision recorded was impacted by the continued improvement in the quality of the loan portfolio. At September 30, 2005, non-performing assets as a percentage of loans and other real estate owned was 0.23% and have not exceeded 0.38% during the last two years. The average ratio of non-performing assets as a percentage of loans and other real estate owned for the Company’s peer group for the most recently reported quarter was 0.76%. The ALLL as a percentage of loans outstanding is 1.09% at September 30, 2005, compared to the average of the Company’s peer group of 1.26% for the most recently reported quarter. The Company had net charge-offs of $1.1 million for the third quarter of 2005. Net charge-offs on depository accounts were $0.7 million, or 63% of total net charge-offs for the quarter ended September 30, 2005.
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While charge-offs on depository accounts are appropriately taken against the ALLL, the revenue associated with depository accounts is reflected in service charges, and has been steadily growing as the Company’s core base of checking accounts has grown. Additionally, the Company’s ALLL also increased by $3.3 million during the nine months ended September 30, 2005 as a result of the Company’s acquisition of Classic.
The ALLL allocated to the commercial loan portfolio (see Table Seven) decreased $2.1 million, or 19.9%, from $10.6 million at December 31, 2004 to $8.5 million at September 30, 2005. This decline was due primarily to the sale of two commercial loans totaling $2.8 million that had been considered classified loans and the Company’s improved commercial loan credit quality, which has favorably impacted historical loss percentages applied to commercial credits not specifically reviewed.
The ALLL allocated to the residential real estate portfolio (see Table Seven) increased $0.9 million, or 30.1%, from $3.2 million at December 31, 2004 to $4.1 million at September 30, 2005. This increase was primarily due to residential real estate loans increasing by $126.7 million, or 27.1%, from December 31, 2004 to September 30, 2005 from the acquisition of Classic and due to an increase historical loss percentages during the first nine months of 2005.
The ALLL allocated to the consumer loan portfolio (see Table Seven) of $2.8 million has increased $0.2 million from December 31, 2004 to September 30, 2005. The outstanding balance of consumer loans, defined as installment, indirect, and credit card loans, increased $15.0 million from December 31, 2004 to September 30, 2005, primarily as a result of the Classic acquisition. The increase in balances was partially offset by lower historical loss percentages in the consumer loan portfolio, which decreased by 19% from December 31, 2004 to September 30, 2005.
The ALLL allocated to overdraft deposit accounts (see Table Seven) increased $0.9 million, or 62.9%, from $1.5 million at December 31, 2004 to $2.4 million at September 30, 2005. Similarly, the balance of overdraft deposit accounts, included in installment loans in the Consolidated Balance Sheets, increased $1.6 million, or 80.7%, from $2.0 million at December 31, 2004 to $3.6 million at September 30, 2005.
As noted previously, when the Company redeemed the outstanding Notes from its retained interests in loan securitizations, it added “previously securitized loans” to its loan portfolio. The carrying value of the previously securitized loans incorporates an assumption for expected cash flows to be received over the life of these loans. To the extent that the present value of expected cash flows is less than the carrying value of these loans, the Company would then need to provide for such losses through the provision and ALLL.
Based on the Company’s analysis of the adequacy of the ALLL and in consideration of the known factors utilized in computing the ALLL, management believes that the ALLL as of September 30, 2005, is adequate to provide for probable losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and potential recoveries of previously charged-off loans. The Company believes that its methodology for determining its ALLL adequately provides for probable losses inherent in the loan portfolio at September 30, 2005.
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TABLE FIVE
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
Balance at beginning of period
Allowance from acquisition
Charge-offs:
Overdraft deposit accounts
Total charge-offs
Recoveries:
Total recoveries
Net charge-offs
Balance at end of period
As a Percent of Average Total Loans:
Net charge-offs (annualized)
Provision for loan losses (annualized)
As a Percent of Non-Performing Loans:
TABLESIX
NON-PERFORMING ASSETS
Non-accrual loans
Accruing loans past due 90 days or more
Previously securitized loans past due 90 days or more
Total non-performing loans
Other real estate owned
Total non-performing assets
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TABLE SEVEN
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
Commercial, financial and agricultural
Real estate – mortgage
Installment loans to individuals
Allowance for Loan Losses
PREVIOUSLYSECURITIZED LOANS
Overview: Between 1997 and 1999, the Company originated and securitized $760 million in 125% loan to value junior-lien underlying mortgages in six separate pools. The Company had a retained interest in the residual cash flows associated with these underlying mortgages after satisfying priority claims. Principal amounts owed to investors in the securitizations were evidenced by securities (“Notes”) that were subject to redemption under certain circumstances. Once the Notes were redeemed, the Company became the beneficial owner of the mortgage loans and recorded the loans as “Previously Securitized Loans” within the loan portfolio. The Company exercised its early redemption option with respect to four of the trusts during 2003 and the remaining two trusts during 2004. As a result, carrying balances for “Retained Interests” became classified as “Previously Securitized Loans”.
Previously Securitized Loans: As the Company redeemed the outstanding Notes, no gain or loss was recognized in the Company’s financial statements and the remaining mortgage loans were recorded in the Company’s loan portfolio, classified as “previously securitized loans,” at the lower of carrying value or fair value. Because the carrying value of the mortgage loans incorporated assumptions for expected prepayment and default rates, the carrying value of the loans was generally less than the actual outstanding contractual balance of the loans. As of September 30, 2005, the Company reported a carrying value of previously securitized loans of $35.6 million, while the actual outstanding contractual balance of these loans was $53.3 million. The difference (“the discount”) between the carrying value and the expected total cash flows from previously securitized loans of $17.7 million at September 30, 2005, is accreted into interest income over the estimated lives of the loans. An impairment charge on previously securitized loans would be provided through the Company’s provision and allowance for loan losses if the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans.
During the first nine months of 2005, defaults on the previously securitized loans have been at a lower rate than expected and thus the expected cash flows have increased. Because the expected cash flows are greater than previously assumed, the accretable yield has increased which has caused the yield on the previously securitized loans to increase. In addition, the Company assumed the servicing of all the pool balances during the second quarter of 2005. This favorably impacted the yield realized on the previously securitized loans due to the elimination of the servicing fees previously paid to the external servicing agent and increased internal collection efforts resulting in enhanced levels of recoveries on previously charged-off loans. For the nine months ended September 30, 2005, the Company has net credit recoveries on previously securitized loans of $2.2 million compared to net losses of $3.0 million for the nine months ended September 30, 2004. While the Company does not expect to maintain recoveries at the 2005 level, it does expect that credit losses will be more favorable than those incurred while the external servicing agent was servicing these loans due to the increased collection efforts from its internal staff.
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During the first nine months of 2005 and 2004, the Company recognized $8.8 million and $10.9 million, respectively, of interest income on its previously securitized loans. The difference between interest income shown below based on cash receipts and interest income reported is due to the recognition of discount accretion. Cash receipts for the three and nine months ended September 30, 2005 and 2004 are summarized in the following table:
Principal receipts
Interest income receipts
Total cash receipts
Based on current cash flow projections, the Company estimates that the carrying value of previously securitized loans will approximate:
As of:
December 31, 2005
December 31, 2006
December 31, 2007
December 31, 2008
NON-INTEREST INCOME AND NON-INTEREST EXPENSE
Non-Interest Income: Net of investment securities gains and legal settlement proceeds, non-interest income increased $5.0 million, or 15.7%, from $31.5 million for the first nine months of 2004 to $36.5 million in 2005. As a result of the Company’s continued focus on growing its retail banking franchise through customer growth and an increase in its pricing structure, the Company experienced a $3.5 million, or 14.4%, increase in service charge revenues in the first nine months of 2005, as compared to the first nine months of 2004. In addition, the Classic acquisition increased service charge revenues by $1.2 million from the date of acquisition through September 30, 2005. The Company also experienced additional revenue of $0.3 million from bank-owned life insurance from the settlement of an insured claim. Insurance commissions decreased $0.2 million from the nine months ended September 30, 2004 compared to the nine months ended September 30, 2005.
As mentioned previously, non-interest income the first nine months of 2004 included $5.5 million of income from the settlement of litigation brought in December 2001 against certain directors and former directors and executive officers of the Company and City National.
Non-Interest Expense: Total non-interest expense increased $1.6 million, or 3.2%, from $49.2 million in the first nine months of 2004 to $50.8 million in the first nine months of 2005. The Classic acquisition increased non-interest expenses by $2.0 million during the first nine months of 2005. Excluding the impact of Classic, non-interest expenses decreased by $0.4 million primarily due to a decrease of $0.9 million of expense in the first nine months of 2004 associated with the derivative action previously discussed and lower compensation expense of $0.5 million primarily as a result of changes in executive management. These decreases were partially offset by increased other expenses of $1.0 million due to increases in bankcard volume and increased business franchise taxes.
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Non-Interest Income: Net of investment securities gains, non-interest income increased $2.1 million, or 19.9%, to $13.0 million in the third quarter of 2005 as compared to $10.9 million in the third quarter of 2004. The largest source of non-interest income is service charges for depository accounts, which increased $2.0 million, or 23.6%, from $8.4 million during the third quarter of 2004 to $10.4 million during the third quarter of 2005. This increase was primarily a reflection of the Classic acquisition that accounted for $0.9 million, or 10.5%, of this increase, as well as an increase in the utilization of services by the Company’s customers.
Non-Interest Expense: Non-interest expenses increased from $15.8 million in the third quarter of 2004 to $17.9 million in the third quarter of 2005. The Classic acquisition increased non-interest expenses by $1.5 million during the third quarter of 2005. Excluding the impact of Classic, non-interest expenses increased by $0.6 million primarily due to increased advertising expenses of $0.3 million and increased other expense of $0.3 million due to increased bankcard volume.
RISK MANAGEMENT
Market risk is the risk of loss due to adverse changes in current and future cash flows, fair values, earnings or capital due to adverse movements in interest rates and other factors, including foreign exchange rates and commodity prices. Because the Company has no significant foreign exchange activities and holds no commodities, interest rate risk represents the primary risk factor affecting the Company’s balance sheet and net interest margin. Significant changes in interest rates by the Federal Reserve could result in similar changes in LIBOR interest rates, prime rates, and other benchmark interest rates that could affect the estimated fair value of the Company’s investment securities portfolio, interest paid on the Company’s short-term and long-term borrowings, interest earned on the Company’s loan portfolio and interest paid on its deposit accounts.
The Company’s Asset and Liability Committee (“ALCO”) has been delegated the responsibility of managing the Company’s interest-sensitive balance sheet accounts to maximize earnings while managing interest rate risk. ALCO, comprised of various members of executive and senior management, is also responsible for establishing policies to monitor and limit the Company’s exposure to interest rate risk and to manage the Company’s liquidity position. ALCO satisfies its responsibilities through monthly meetings during which product pricing issues, liquidity measures and interest sensitivity positions are monitored.
In order to measure and manage its interest rate risk, the Company uses an asset/liability management and simulation software model to periodically update the interest sensitivity position of the Company’s balance sheet. The model is also used to perform analyses that measure the impact on net interest income and capital as a result of various changes in the interest rate environment. Such analyses quantify the effects of various interest rate scenarios on projected net interest income. The Company’s policy objective is to avoid negative fluctuations in net income or the economic value of equity of more than 15% within a 12-month period, assuming an immediate parallel increase or decrease of 300 basis points. The Company measures the long-term risk associated with sustained increases and decreases in rates through analysis of the impact to changes in rates on the economic value of equity.
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During the second quarter of 2005, the Company entered into three separate $100 million notional value interest rate floors, with terms of 3, 4 and 5 years for each respective instrument. These instruments provide the Company protection against the impact of declining interest rates on the Company’s variable rate home equity loans. At September 30, 2005, the notional value of the interest rate floor agreements was $300 million and had related market losses of $0.5 million, net of tax, which is recorded in other comprehensive income.
The following table summarizes the sensitivity of the Company’s net income to various interest rate scenarios. The results of the sensitivity analyses presented below differ from the results used internally by ALCO in that, in the analyses below, interest rates are assumed to have an immediate and sustained parallel shock. The Company recognizes that rates are volatile, but rarely move with immediate and parallel effects. Internally, the Company considers a variety of interest rate scenarios that are deemed to be possible while considering the level of risk it is willing to assume in “worst-case” scenarios such as shown by the following:
Immediate Parallel Change
in Interest Rates
(basis points)
Percentage Change in
Net Interest Income from Base over One Year
+300
+200
+100
-100
-200
These results are highly dependent upon assumptions made by management, including, but not limited to, assumptions regarding the manner in which interest-bearing demand deposit and saving deposit accounts reprice in different interest rate scenarios, pricing behavior of competitors, prepayments of loans and deposits under alternative rate environments, and new business volumes and pricing. As a result, there can be no assurance that the results above will be achieved in the event that interest rates increase or decrease during 2005 and beyond.
Based upon the results above, the Company believes that its net income is positively correlated with increasing rates as compared to the level of net income the Company would expect if interest rates remain flat. However, these results do not necessarily imply that the Company will experience increases in net income if market interest rates rise. In fact, the Company has significant exposure due to projected decreases in outstanding balances of previously securitized loans. Between October 2005 and December 2006, based upon the Company’s projected reductions in outstanding balances of previously securitized loans, assuming that market interest rates remain unchanged, and assuming that other loan and deposit balances remain unchanged, the Company anticipates a reduction in net interest income of approximately 6% and a corresponding reduction in net income of approximately 6%. The table above demonstrates that increases in the level of market interest rates could partially or fully offset this impact.
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LIQUIDITY
The Company evaluates the adequacy of liquidity at both the Parent Company level and at City National. At the Parent Company level, the principal source of cash is dividends from City National. Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. From January 1, 2003 through September 30, 2005, City National received regulatory approval to pay $160.1 million of cash dividends to the Parent Company, while generating net profits of $136.1 million. Therefore, City National will be required to obtain regulatory approval prior to declaring any cash dividends to the Parent Company throughout 2005. Although regulatory authorities have approved prior cash dividends, there can be no assurance that future dividend requests will be approved.
The Parent Company used cash obtained from the dividends received primarily to: (1) pay common dividends to shareholders, (2) remit interest payments on the Company’s trust-preferred securities, (3) fund the acquisition of Classic Bancshares, and (4) fund repurchase of the Company’s common shares.
Over the next 12 months, the Parent Company has an obligation to remit interest payments approximating $2.6 million on the junior subordinated debentures held by City Holding Capital Trust. Additionally, the Parent Company anticipates continuing the payment of dividends, which are expected to approximate $18.2 million, to common shareholders. However, interest payments on the debentures can be deferred for up to five years under certain circumstances and dividends to shareholders can, if necessary, be suspended. In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $0.2 million of additional cash over the next 12 months. As of September 30, 2005, the Parent Company reported a cash balance of $31.4 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National, if approved, will be adequate to satisfy its funding and cash needs over the next twelve months.
Excluding the interest and dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2005 other than the repayment of its $28.8 million obligation under the debentures held by City Holding Capital Trust. However, this obligation does not mature until April 2028, or earlier at the option of the Parent Company. It is expected that the Parent Company will be able to obtain the necessary cash, either through dividends obtained from City National or the issuance of other debt, to fully repay the debentures at their maturity.
City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the FHLB and other financial institutions. As of September 30, 2005, deposits and capital significantly fund City National’s assets. However, City National maintains borrowing facilities with the FHLB and other financial institutions that are accessed as necessary to fund operations and to provide contingency funding mechanisms. As of September 30, 2005, City National has the capacity to borrow an additional $530.9 million from the FHLB under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systematic financial industry crisis. Additionally, City National maintains a significant percentage (91.4% or $601.5
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million at September 30, 2005) of its investment securities portfolio in the highly liquid available for sale classification. As such, these securities could be liquidated, if necessary, to provide an additional funding source. City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary.
The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. The Company’s net loan to asset ratio is 63.3% as of September 30, 2005 and deposit balances fund 74.9% of total assets. Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 43.2% of the Company’s total assets. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has significant investment security balances that totaled $657.9 million at September 30, 2005, and that greatly exceeded the Company’s non-deposit sources of borrowing which totaled $346.5 million.
As illustrated in the Consolidated Statements of Cash Flows, the Company generated $36.0 million of cash from operating activities during the first nine months of 2005, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings. The Company generated $10.8 million of cash from investing activities during the first nine months of 2005. The Company used $43.9 million of cash in financing activities during the first nine months of 2005.
CAPITAL RESOURCES
During the nine months of 2005, Shareholders’ Equity increased $74.3 million, or 34.4%, from $216.1 million at December 31, 2004 to $290.4 million at September 30, 2005. This increase was primarily due to the issuance of 1,580,034 shares, net of 108,173 shares owned and transferred to treasury, for the acquisition of Classic Bancshares, which increased equity by $54.3 million. In addition, the Company reported net income of $37.2 million for the first nine months of 2005, which was partially offset by cash dividends declared during the period of $13.2 million and a $3.0 million reduction in accumulated other comprehensive income. The reduction in accumulated other comprehensive income was due to unrealized losses on the Company’s available for sale investment securities and interest rate swaps.
During the third quarter of 2005, the Company repurchased 34,100 common shares at a weighted average price of $35.40 as part of a 1 million share repurchase plan authorized by the Board of Directors on June 29, 2005. On June 29, 2005, the Company announced that the Board of Directors authorized the Company to buy back up to 1,000,000 shares of its common shares (approximately 5% of outstanding shares) in open market transactions at prices that are accretive to the earnings per share of continuing shareholders. No time limit was placed on the duration of the share repurchase program. As part of this authorization, the Company rescinded the previous share repurchase program plan approved in June 2002. As of September 30, 2005, the Company may repurchase an additional 965,900 shares from time to time depending on market conditions under the authorization.
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Regulatory guidelines require the Company to maintain a minimum total capital to risk-adjusted assets ratio of 8.0%, with at least one-half of capital consisting of tangible common stockholders’ equity and a minimum Tier I leverage ratio of 4.0%. Similarly, City National is also required to maintain minimum capital levels as set forth by various regulatory agencies. Under capital adequacy guidelines, City National is required to maintain minimum total capital, Tier I capital, and leverage ratios of 8.0%, 4.0%, and 4.0%, respectively. To be classified as “well capitalized,” City National must maintain total capital, Tier I capital, and leverage ratios of 10.0%, 6.0%, and 5.0%, respectively.
The Company’s regulatory capital ratios remained strong for both City Holding and City National as illustrated in the following table:
December 31
2004
City Holding:
Total
Tier I Risk-based
Tier I Leverage
City National:
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The information called for by this item is provided under the caption “Risk Management” under Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 4 – CONTROLS AND PROCEDURES
Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934) 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 effective in timely alerting them to material information relating to the Company required to be included in the Company’s periodic SEC filings. There has been no change in the Company’s internal control over financial reporting during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The Company is engaged in various legal actions that it deems to be in the ordinary course of business. The Company believes that it has adequately provided for probable costs of current litigation. As these legal actions are resolved, however, the Company could realize positive and/or negative impact to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, either positive or negative, or that no material actions may be presented in the future.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
The following table sets forth information regarding the Company’s common stock repurchases transacted during the quarter:
Period
TotalNumber
of SharesPurchased
Total Number
as Part of Publicly
Announced Plans
or Programs (a)
July 1 – July 31, 2005
August 1 – August 31, 2005
September 1 – September 30, 2005
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits
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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.
/s/ Charles R. Hageboeck
/s/ David L. Bumgarner
Date: November 2, 2005
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