SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For the transition period from to
Commission File No. 0-2989
COMMERCE BANCSHARES, INC.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
As of November 11, 2003, the registrant had outstanding 65,020,228 shares of its $5 par value common stock, registrant’s only class of common stock.
TABLE OF CONTENTS
Commerce Bancshares, Inc. and Subsidiaries
Form 10-Q
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
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The accompanying consolidated financial statements include the accounts of Commerce Bancshares, Inc. and all majority-owned subsidiaries (the Company). All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 2002 data to conform to current year presentation. Results of operations for the three and nine month periods ended September 30, 2003 are not necessarily indicative of results to be attained for any other period.
The significant accounting policies followed in the preparation of the quarterly financial statements are the same as those disclosed in the 2002 Annual Report on Form 10-K.
The Company has various stock option plans offered to certain key employees of the Company and its subsidiaries. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the fair value of the underlying common stock on the date of grant. Effective January 1, 2003, the Company voluntarily adopted the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”, pursuant to which the cost of stock options are expensed. In accordance with the transition provisions of Statement of Financial Accounting Standards No. 148, the Company has elected to restate all prior periods to reflect the compensation expense that would have been recognized had the recognition provisions of Statement No. 123 been applied to all options granted to employees after January 1, 1995. The after-tax per share impact for the nine months ended September 30, 2003 and 2002 was a decline of $.04 in each period. The Company expects the overall annual impact of applying the statement to be $.05 per share in 2003.
Effective January 1, 2003, the Company acquired The Vaughn Group, Inc., a direct equipment lessor based in Cincinnati, Ohio. At acquisition, The Vaughn Group, Inc. (Vaughn) had a lease portfolio of approximately $38.7 million consisting mainly of data processing hardware. In addition, Vaughn serviced approximately $425 million of lease agreements for other institutions involving capital equipment, ranging from production machinery to transportation equipment. The Company issued stock valued at $6.0 million and paid cash of $2.5 million in the acquisition. The acquisition was accounted for as a purchase, and accordingly, the consolidated results include Vaughn for the entire nine months of 2003. Goodwill of $5.3 million was recognized in the transaction and recorded in the 2003 consolidated balance sheet.
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The following is a summary of the allowance for loan losses.
Investment securities, at fair value, consist of the following at September 30, 2003, and December 31, 2002.
Equity securities included short term investments in money market mutual funds of $101,006,000 at September 30, 2003, and $150,905,000 at December 31, 2002.
The following table presents information about the Company’s intangible assets which have estimable useful lives.
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The Company does not have any intangible assets that are not currently being amortized. Aggregate amortization expense on intangible assets was $453,000 and $508,000, respectively, for the three month periods ended September 30, 2003 and 2002, and $1,352,000 and $1,900,000 for the nine month periods ended September 30, 2003 and 2002. Estimated annual amortization expense for the years 2003 through 2007 is as follows.
The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.
At September 30, 2003, a liability in the amount of $5.0 million, representing the carrying value of the guarantee obligations associated with the standby letters of credit, was recorded in accordance with Financial Accounting Standards Board Interpretation 45. This amount will be amortized into income over the life of the commitment. The contract amount of these letters of credit, which represents the maximum potential future payments guaranteed by the Company, was $294.7 million at September 30, 2003.
The Company guarantees payments to holders of certain trust preferred securities issued by a wholly owned grantor trust. The securities are due in 2030 and are redeemable beginning in 2010. The maximum potential future payments guaranteed by the Company, which includes future interest and principal payments through maturity, was approximately $15.5 million at September 30, 2003. At September 30, 2003, the Company had a recorded liability of $4.0 million in principal and accrued interest to date, representing amounts owed to the security holders.
8. Common Stock
The shares used in the calculation of basic and diluted income per share are shown below.
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9. Other Comprehensive Income
The Company’s only component of other comprehensive income during the periods presented below was the unrealized holding gains and losses on available for sale investment securities.
10. Change in Estimated Effective Income Tax Rate
For interim reporting purposes, income tax expense is determined by applying the expected annual effective tax rate to income before income taxes. The expected annual effective tax rate is periodically evaluated for changing facts and circumstances. Subsequent to September 30, 2003, the Company completed its review of the estimated annual effective tax rate for 2003, and determined that the rate should be reduced. The estimated effective tax rate has been reduced to 29.0% for the nine months ended September 30, 2003, as compared to the effective tax rate of 31.3% for the six months ended June 30, 2003. The primary reason for the reduction in the effective tax rate is that the Company has adjusted the recognition of the tax benefits for certain reorganization initiatives; related tax benefits of approximately $3.4 million, or $.05 per diluted share, recognized in the three months ended September 30, 2003 should have been recognized in the previous two quarters. The Company has determined that it is not necessary to revise the consolidated financial statements included in its Form 10-Q reports for the periods ended March 31, 2003 and June 30, 2003 because the impact in those periods is not material.
11. Segments
The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The Consumer segment includes the retail branch network, consumer finance, bankcard, student loans and discount brokerage services. The Commercial segment provides corporate lending, leasing, and international services, as well as business, government deposit and cash management services. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment management services.
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The following table presents selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues between the three segments.
The information presented above was derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. This information is based on internal management accounting policies, which have been developed to reflect the underlying economics of the businesses. The policies address the methodologies applied in connection with funds transfer pricing. Funds transfer pricing was used in the determination of net interest income by assigning a standard cost (credit) for funds used (provided) to assets and liabilities based on their maturity, prepayment and/or repricing characteristics.
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The performance measurement of the operating segments is based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The information is also not necessarily indicative of the segments’ financial condition and results of operations if they were independent entities.
The Company uses derivative instruments, on a limited basis, primarily to hedge the variability in interest payments or protect the value of certain assets and liabilities recorded in its balance sheet from changes in interest rates. The Company has interest rate swaps with a total notional amount of $39.2 million, of which three swaps with a notional amount of $22.1 million are designated as fair value hedges of certain fixed rate loans. Through its International Department, the Company enters into foreign exchange contracts consisting mainly of contracts to purchase or deliver foreign currency transactions for customers at a specific future date. Also, mortgage loan commitments and forward sales contracts are derived from the Company’s mortgage banking operation in which fixed rate personal real estate loans are originated and sold to other institutions.
The Company’s usage of derivative instruments is detailed below.
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The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Company’s 2002 Annual Report on Form 10-K. Results of operations for the three and nine month periods ended September 30, 2003, are not necessarily indicative of results to be attained for any other periods.
Forward Looking Information
This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include: changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, governmental legislation and regulation, fluctuations in interest rates, changes in liquidity requirements, demand for loans in the Company’s market area, and competition with other entities that offer financial services.
Critical Accounting Policies
Critical accounting policies are those which are both most important to the portrayal of the Company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The Company’s critical accounting policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, and accounting for income taxes, all of which involve significant judgment by management.
The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the collectability of the loan portfolio. While these estimates are based on substantive methods for determining allowance requirements, nevertheless, actual outcomes may differ significantly from estimated results. Further discussion of the methodologies used in establishing this reserve is provided in the Provision and Allowance for Loan Losses section of this discussion.
The parent holding company and its Small Business Investment subsidiaries have made numerous private equity and venture capital investments, which totaled $25.0 million at September 30, 2003. These private equity and venture capital securities are reported at estimated fair values in the absence of readily ascertainable fair values. Where no market quotation exists, management believes that the cost of an investment is initially the best indication of estimated fair value unless there have been significant subsequent positive or negative developments that justify an adjustment to the fair value estimate. The values assigned to these securities where no market quotations exist are based upon available information and management’s judgment. Although management believes its estimates of fair value are reasonable and conservatively reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team and
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The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of examinations by the IRS and state agencies, could materially impact the Company’s financial position and its results of operations.
Selected Financial Data
Results of Operations
Summary
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For the quarter ended September 30, 2003, net income amounted to $54.9 million, an increase of 9.0% over the third quarter of the previous year. Diluted earnings per share increased 13.7% to $.83 for the third quarter of 2003, compared to $.73 for the third quarter of 2002. The return on average assets for the current quarter was 1.60%, unchanged from the third quarter of 2002. The return on average equity was 14.96% compared to 14.36% in 2002. The Company’s efficiency ratio rose slightly to 58.56% for the current quarter, compared to 57.21% in the third quarter of 2002. The increase in net income over the third quarter of last year was the result of an increase in non-interest income of $7.4 million or 10.6% and a decrease of income tax expense of $6.8 million, offset by lower net interest income and higher expenses. Compared to the third quarter of last year, net interest income decreased 3.8% while non-interest expense grew 3.9%; the provision for loan losses also grew by $462 thousand, or 5.0%.
Net income for the first nine months of 2003 was $152.7 million, a 5.0% increase over the first nine months of 2002. Diluted earnings per share were $2.28 compared to $2.09 for the first nine months of last year, an increase of 9.1%. Most of the increase in net income was due to higher levels of non-interest income, which rose $17.2 million, or 8.3%, and a lower effective income tax rate. Net interest income improved slightly, with an increase of $2.9 million. Non-interest expense rose $13.2 million, or 3.9%, and the provision for loan losses grew $6.4 million. The efficiency ratio for the first nine months of 2003 was 59.52% compared to 58.71% in 2002.
Effective January 1, 2003, the Company elected to expense the cost of stock options by retroactively applying the rules of Financial Accounting Statement 123. The after-tax per share impact for the nine months ended September 30, 2003 and 2002 was a decline of $.04 in each period. The Company expects the overall annual impact of expensing the cost of stock options to be $.05 per share for 2003.
Effective January 1, 2003, the Company acquired The Vaughn Group, Inc. (Vaughn), a leasing company based in Cincinnati, Ohio. Vaughn was a direct lessor with a lease portfolio at December 31, 2002 of approximately $38.7 million consisting mainly of data processing hardware. In addition, Vaughn serviced approximately $425 million of lease agreements for other institutions. The Company issued common stock valued at $6.0 million and paid cash of $2.5 million in the acquisition.
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Net Interest Income
The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.
Analysis of Changes in Net Interest Income
Net interest income for the third quarter of 2003 was $122.0 million, a decrease of $4.8 million, or 3.8%, compared with the same period last year. For the first nine months of 2003, net interest income totaled $374.9 million, an increase of $2.9 million, or .8%, compared with the first nine months of last year. The net interest margin for the third quarter of 2003 declined to 3.89% compared with 4.40% in the third quarter of last year, while the net interest margin for the first nine months of 2003 was 4.07% compared with 4.40% last year.
The decrease of $4.2 million in current quarter net interest income (tax equivalent basis), as compared to the third quarter of 2002, was mainly the result of lower yields on loans and investment securities, along with higher average balances of federal funds purchased and securities sold under repurchase agreements,
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Growth in average loan balances of $223.5 million over the third quarter of last year helped to partially offset lower interest margins mainly in the areas of business real estate and consumer loans. Also, average balances of investment securities increased $838.4 million over this same time frame, but rates earned declined 118 basis points on the overall portfolio. Much of this decline in rates was due to normal maturities on securities coupled with much higher levels of principal prepayments on mortgage-backed, CMO, and asset-backed securities, which were reinvested at lower rates. During the quarter, principal prepayments on mortgage-backed, CMO, and asset-backed securities totaled $472.7 million compared with $87.7 million in principal prepayments received in the third quarter of 2002.
As shown in the table above, total interest income (tax equivalent) in the current quarter decreased $14.8 million compared with the third quarter of 2002. This decline was mainly the result of lower interest on loans ($11.7 million) and investment securities ($3.0 million). The reduction in average rates earned on loans of 75 basis points, compared to the third quarter of 2002, had the impact of reducing interest income by $17.0 million. This was partially offset by 2.9% growth in average loans as noted above which contributed additional interest earnings of $5.3 million. The decline in interest on investment securities noted above was attributable to lower rates earned, which reduced interest income by $13.6 million. Higher average balances of investment securities, as mentioned above, offset much of this decline by increasing interest income $10.5 million.
Compared to the first nine months of 2002, total interest income decreased $26.9 million. The decline reflects the same trends noted above in the quarterly comparison, with declines in average overall yields due to the lower interest rate environment, partly offset by higher balances in loans and investment securities. Interest earned on certain inflation-indexed treasury securities increased $5.9 million over the same period in 2002, which helped to somewhat offset the effects of lower rates on investment securities. Also during the nine months in 2003, adjustments totaling $1.4 million were made, reducing interest income on the Company’s CMO, mortgage-backed and asset-backed securities, to recognize the result of faster principal payments received on these securities. Average tax equivalent yields on total interest earning assets for the nine months were 5.03% in 2003 and 5.81% in 2002.
For the three months ended September 30, 2003, total interest expense decreased $10.4 million compared to the same quarter last year. This was due mainly to a reduction in deposit rates in all interest bearing deposit categories, which had the effect of reducing interest expense by $10.3 million, along with a decline in average retail certificate of deposit balances. The average balance of federal funds purchased, which have overnight maturities, increased by $443.0 million while securities sold under agreements to repurchase increased by $273.5 million. Much of the proceeds of these borrowings were used to fund loan growth or the purchase of investment securities.
For the first nine months of 2003, total interest expense decreased $29.7 million compared with 2002. Average rates paid on deposit balances declined 52 basis points, and rates paid on total borrowings also declined 52 basis points. Higher balances in both federal funds purchased and securities sold under repurchase agreements partly offset the decline in rates. The overall average cost of total interest bearing liabilities was 1.10% for the first nine months of 2003 compared to 1.61% for the same period in 2002.
Summaries of average assets and liabilities and the corresponding average rates earned/paid are located at the end of this discussion.
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Non-Interest Income
For the third quarter of 2003, total non-interest income amounted to $76.9 million compared with $69.5 million in the same quarter last year, an increase of 10.6%. This increase resulted from growth in deposit account, bank card, operating lease, and trust fee revenues. Deposit account fees in the third quarter grew 15.7% over last year as a result of a 21.7% increase in overdraft fees and higher commercial cash management revenues. The large increase in overdraft fees was due to both pricing increases in the Company’s Missouri markets coupled with improved collection efficiencies. Bank card fees for the quarter increased 5.4% over the same period last year, primarily a result of a 14.2% increase in merchant interchange revenue and 9.1% growth in cardholder fees. Debit card fees, however, declined 5.9% because of lower transaction pricing which went into effect in August as a result of the VISA lawsuit settlement, which is described below. Trust fees for the current quarter were up 4.7% over the same quarter last year as a result of higher fees on personal and corporate trust accounts due to improved asset valuations upon which fees are charged. Other non-interest income in the third quarter of 2003 included gains of $1.8 million on student loan sales, which did not occur in the third quarter of 2002. In addition, operating lease revenues of $1.1 million, related to a leasing subsidiary which was acquired at the beginning of 2003, were not present in the third quarter of 2002.
Non-interest income for the nine months ended September 30, 2003 increased $17.2 million, or 8.3%, over the first nine months of 2002. Deposit account charges rose $5.8 million, or 8.6%, due to higher overdraft fees and cash management fee revenue. Bank card transaction fees rose $4.2 million, or 10.0% ($1.3 million in merchant, $1.8 million in credit card, and $1.2 million in debit card fees) over the prior period. Other non-interest income increased $3.9 million in 2003 compared to the previous year, mainly due to higher levels of student loan sales and the additional operating lease revenues mentioned above. These were partly offset by gains recognized in 2002 from the sale of several bank branches and the sale of the Company’s interest in a community bank. Other declines occurred in trust fees, which fell by $923 thousand from 2002, and consumer brokerage revenue, which decreased $899 thousand in fees from mutual fund sales.
Net securities gains amounted to $896 thousand for the third quarter of 2003 compared to $1.4 million in the third quarter of last year. On a year to date basis, such gains amounted to $5.3 million and $586 thousand for 2003 and 2002, respectively. The net gain in 2003 included gains of $6.2 million from sales from the banks’ available for sale portfolio, partly offset by losses of $1.4 million on private equity investments held by venture capital subsidiaries. In comparison, the net gain in 2002 included bank gains of $3.0 million, offset by private equity investment losses of $2.4 million.
As was mentioned in a previous report, in April 2003, VISA U.S.A., Inc. reached an agreement to settle litigation concerning debit card interchange fees with a large group of retailers. As a result of this
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Non-Interest Expense
Non-interest expense for the quarter amounted to $116.4 million, an increase of $4.4 million, or 3.9%, compared with $112.0 million recorded in the third quarter of last year. Compared with the third quarter of last year, salary costs increased 2.3% mainly due to normal merit increases, but offset by lower costs for part-time, over-time and contract labor. Benefit costs declined 4.3% mainly due to lower medical and 401K contribution expenses, offset by higher pension costs. Full time equivalent employees totaled 4,986 and 5,017 at September 30, 2003 and 2002, respectively. Occupancy costs grew $616 thousand, or 7.0%, mainly as a result of higher depreciation costs resulting from a recently renovated office building. Increased costs were also incurred for equipment, data processing, and supplies and communication. Included in other non-interest expense were operating lease depreciation and associated costs totaling $819 thousand related to the leasing subsidiary mentioned above, which were not present last year. Also, minority interest expense, which resulted from venture capital gains reported by a 53%-owned affiliate, increased $1.0 million compared to the previous year when venture capital losses were recorded.
Non-interest expense rose $13.2 million, or 3.9%, over the first nine months of 2002. Salaries and employee benefits increased $7.4 million, or 3.9%, due to salary merit increases, higher incentive expense, and higher pension plan expense. Occupancy expense increased $3.8 million largely due to higher depreciation and operating costs related to the building renovation noted above. Equipment costs rose $1.2 million due to higher depreciation and service contract expense. Supplies and communication expense increased $989 thousand, resulting from enhancements in computer network communications. Data processing and software expense declined $4.4 million, which resulted mainly from the internalization of the Company’s mainframe computer operations in the second quarter of 2002. Other non-interest expense increased $4.6 million, due largely to new leasing-related costs of $2.6 million and an increase in minority interest expense, as mentioned above.
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Provision and Allowance for Loan Losses
The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. The Company combines estimates of the reserves needed for loans evaluated on an individual basis for impairment with estimates of the reserves needed for pools of loans with similar risk characteristics. The process to determine reserves uses such tools as the Company’s “watch loan list”, migration models and actual loss experience to identify both individual loans and pools of loans and the amount of reserves that are needed. Additionally, management determines the amount of reserves necessary to offset credit risk issues associated with loan concentrations, economic uncertainties, industry concerns, adverse market changes in estimated or appraised collateral values, and other subjective factors.
In using this process and the information available, management must use various assumptions and considerable judgment to determine the overall level of the allowance for loan losses. Because of these subjective factors, actual outcomes of inherent losses can differ from original estimates. The process of determining adequate levels of the allowance for loan losses is subject to regular review by the Company’s internal loan review team and by outside regulators.
Net loan charge-offs for the third quarter of 2003 amounted to $9.7 million compared with $9.5 million in the second quarter of 2003 and $8.6 million in the third quarter of last year. The ratio of net charge-offs to total average loans this quarter was .48%, compared with .47% in the second quarter of 2003 and .44% in the same quarter last year. Net charge-offs for the current quarter included a $1.5 million charge-off of a commercial loan, coupled with higher consumer and credit card charge-offs.
For the third quarter of 2003, net charge-offs on average credit card loans increased to 3.66%, compared with 3.35% in the third quarter of last year. Also, personal loan net charge-offs (mainly charge-offs on automobile loans) increased this quarter and amounted to .45% of average personal loans compared to .38% in the same period last year.
Net charge-offs during the first nine months of 2003 amounted to $28.1 million, compared to $22.6 million in the prior period. Net charge-offs increased in the business, credit card, and personal banking loan categories by $2.4 million, $1.5 million, and $1.3 million, respectively. The annualized net charge-off ratios were .47% in 2003 and .39% in 2002.
The provision for loan losses for the quarter totaled $9.7 million, down slightly from the provision recorded in the second quarter of 2003, but up from $9.2 million recorded in the third quarter of 2002. The provision for loan losses was $29.7 million in the first nine months of 2003 compared to $23.3 million in the same period in 2002. During the first nine months of 2003, the provision exceeded total net loan charge-offs by $1.6 million.
The allowance for loan losses at September 30, 2003 amounted to $132.7 million, or 1.67% of total loans, and represented 410% of total non-performing loans. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at September 30, 2003.
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Risk Elements of Loan Portfolio
The following table presents non-performing assets and loans which are past due 90 days and still accruing interest. Non-performing assets include non-accruing loans and foreclosed real estate. Loans are placed on non-accrual status when principal or interest is past due 90 days or more unless the loan is well-secured and in the process of collection or when, in the opinion of management, full collection of principal or interest is unlikely. Consumer loans are exempt under regulatory rules from being classified as non-accrual since they are normally charged off when they become 120 days past due. Those loans, anticipated to be collected, are included in the totals below for loans past due 90 days and still accruing interest.
Non-accrual loans at September 30, 2003 totaled $32.4 million, an increase of $4.3 million over amounts recorded at December 31, 2002. Lease-related loans comprise 45.2% of the September 30, 2003 non-accrual loan total, with the remainder primarily relating to business or business real estate loans. Total loans past due 90 days or more and still accruing interest amounted to $19.1 million as of September 30, 2003, and have decreased $3.3 million since December 31, 2002. The decline in past due loans has occurred mainly in business and business real estate loans, while past due personal mortgages, consumer and credit card loans have remained fairly constant over the past nine months.
Income Taxes
The effective tax rate for the nine months ended September 30, 2003 was 29.0%, as compared to 32.3% for the nine months ended September 30, 2002. The effective tax rate is lower in 2003 primarily because of increased tax benefits that result from reorganization initiatives. The reorganization initiatives have favorably affected the Company’s effective tax rate; the impact is expected to be approximately 5% of 2003 income before taxes. There can be no assurance that such favorable effects will be recognized on a continuing basis after December 31, 2003.
For the three months ended September 30, 2003, the effective tax rate was 24.6%, as compared to 32.9% for the three months ended September 30, 2002. The principal reason for the lower effective tax rate in 2003 is described above. Also, as more fully described in Note 10 to the consolidated financial statements, the tax provision for the three months ended September 30, 2003 includes a favorable adjustment of approximately $3.4 million due to the adjustment of the year to date effective tax rate. In addition, the effective tax rate for the three months ended September 30, 2003 was also reduced for the utilization of additional state tax credits purchased by a subsidiary bank, the contribution of appreciated artwork and receipt of tax-free dividend income from the sale of a venture capital investment.
Financial Condition
Balance Sheet
Total assets of the Company were $13.6 billion at September 30, 2003 compared to $13.3 billion at December 31, 2002, an increase of 2.5%. Average earning assets during the nine months ended September 30, 2003 totaled $12.4 billion, consisting of loans totaling $8.0 billion and investment securities of $4.3 billion.
During the first nine months of 2003, total loans increased $69.2 million over balances at December 31, 2002. The increase was the result of growth of $130.5 million in business real estate loans and
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Available for sale investment securities, excluding fair value adjustments, increased $416.4 million, or 10.2%, at September 30, 2003 over December 31, 2002. The increase resulted from purchases of securities with liquidity obtained from increases in deposits and borrowings. The growth occurred mainly in inflation-indexed treasuries and asset-backed auto and credit card securities, and was partly offset by reductions in balances on certain mortgage-backed and CMO securities, which were impacted by accelerated principal prepayments. The adjustment to fair value at September 30, 2003 amounted to a net unrealized gain of $114.1 million, which was a decrease of $40.9 million from the year end fair value adjustment. The total investment securities portfolio, at fair value, amounted to $4.6 billion at September 30, 2003, and was comprised mainly of U.S. government and federal agency (33.9%), mortgage-backed (29.8%), and other asset-backed (27.1%) investment securities.
Total deposits increased $41.2 million at September 30, 2003 compared to December 31, 2002. The increase was due mainly to increases of $66.7 million in non-interest bearing demand deposits and $123.6 million in interest checking, partly offset by a decrease of $173.7 million in C.D.’s of less than $100,000.
Compared to 2002 year end balances, total borrowings at September 30, 2003 increased $345.6 million. The Company’s short-term borrowings of federal funds purchased and securities sold under agreements to repurchase vary depending on daily liquidity requirements. These borrowings rose $271.9 million during the first nine months of 2003 to a balance of $1.7 billion at September 30, 2003. Longer-term borrowings rose $73.7 million due to additional FHLB advances of $44.4 million and lease financing debt of $24.8 million assumed in the Company’s 2003 acquisition of a leasing subsidiary.
Liquidity and Capital Resources
Liquidity represents the Company’s ability to obtain cost-effective funding to meet the needs of customers as well as the Company’s financial obligations. Liquidity can be provided through adjustment of the level of short-term overnight investments such as federal funds sold and securities purchased under agreements to resell, in addition to the available for sale investment securities held by subsidiary banks. These liquid assets had a fair value of $4.4 billion at September 30, 2003, which included $977.7 million pledged to secure public deposits, discount window borrowings, and other purposes as required by law. Within the next twelve months, approximately $1.3 billion of the banks’ available for sale portfolio is expected to mature or pay down. The available for sale bank portfolio included an unrealized net gain in fair value of $80.8 million at September 30, 2003 compared to an unrealized net gain of $119.4 million at December 31, 2002. Liquidity can also be obtained through secured advances from the FHLB, of which certain subsidiary banks are members. These borrowings are secured under a blanket collateral agreement including primarily residential mortgages as well as all unencumbered assets and stock of the borrowing bank. Advances outstanding approximated $367.1 million at September 30, 2003, compared to $322.7 million at December 31, 2002. Of the outstanding FHLB advances, $100.2 million are payable during the next 12 months. An additional $122.2 million is available under FHLB lines of credit at September 30, 2003.
The liquid assets of the parent bank holding company, Commerce Bancshares, Inc. (Parent), consist primarily of short-term money market mutual funds, corporate bonds and stock, U.S. government and federal agency securities and commercial paper. The fair value of these assets was $245.8 million at
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The Company maintains a treasury stock buyback program; and effective January 2003, was authorized by the Board of Directors to repurchase up to 4 million shares of its common stock. During the first nine months of 2003, the Company purchased approximately 2.2 million shares at an average cost of $39.96. The Company has routinely used these reacquired shares to fund annual stock dividends and various stock option programs.
In July 2003, the Board of Directors approved an increase in the Company’s regular quarterly cash dividend. Shareholders received a third quarter cash dividend of $.225 per share, a 36.4% increase compared to the $.165 per share paid in the first and second quarters of 2003. As a result of the per share increase, total dividends paid in the third quarter were $3.9 million higher than those paid in the second quarter. In October 2003, the Board approved a fourth quarter cash dividend of $.225 per share, along with the 10th consecutive annual 5% stock dividend, payable December 12, 2003.
The Company had an equity to asset ratio of 10.8% based on 2003 average balances. As shown in the following table, the Company’s capital exceeded the minimum risk-based capital and leverage requirements of the regulatory agencies.
The following discussion is based on cash flow amounts that exclude changes resulting from bank acquisitions and branch dispositions. The Company’s cash and cash equivalents (defined as “Cash and due from banks” on the accompanying balance sheets) were $542.9 million at September 30, 2003, a decrease of $167.5 million from December 31, 2002. Contributing to the net cash outflow were $426.1 million in purchases of investment securities, net of sales and maturities, treasury stock purchases of $89.3 million, and a net increase of $79.8 million in overnight investments in federal funds sold and resell agreements. These cash outflows were partly offset by deposit growth of $49.9 million, a net increase in total borrowings of $297.3 million, and $184.7 million generated from operating activities.
The Company has various commitments and contingent liabilities which are properly not reflected on the balance sheet. Loan commitments (excluding derivative instruments and lines of credit related to credit cards) totaled approximately $3.1 billion, and commercial letters of credit totaled $23.3 million at September 30, 2003.
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Impact of Recently Issued Accounting Standards
As discussed in the Company’s 2002 Annual Report on Form 10-K, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities”, in January 2003, which requires that investments in variable interest entities (VIE) be consolidated by the entity that has a variable interest that will absorb a majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s expected returns, or both. The consolidation requirements of Interpretation No. 46 were originally effective September 30, 2003 for investments in VIE’s made prior to February 1, 2003, and effective March 31, 2003 for investments in VIE’s made on February 1, 2003 or thereafter. As mentioned in the previous report on Form 10-Q, the Company has several Small Business Investment Company (SBIC)-related private equity investments and other investments in low income housing partnerships which are being evaluated under several provisions of Interpretation No. 46. The FASB has currently elected to reconsider provisions of Interpretation No. 46 concerning SBIC-related private equity investments and does not currently require these types of investments to be consolidated. Also, the FASB subsequently deferred the effective date until December 31, 2003 for all investments in VIE’s made prior to February 1, 2003. If consolidation is ultimately required for any of these investments, the Company’s assets, liabilities, revenues and expenses would be adjusted to reflect the consolidation of these investments; however, it is not expected that net income would be significantly affected.
The FASB issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”, in May 2003. Statement No. 150 established standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. The Statement requires that an issuer classify financial instruments that are within its scope as a liability (or an asset in some circumstances). Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; and (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominately based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares, or variations inversely related to changes in the fair value of the issuer’s equity shares. Statement No. 150 was effective for contracts entered into or modified after May 31, 2003, and was otherwise effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of the Statement on July 1, 2003 did not have a significant impact on the Company’s financial statements.
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AVERAGE BALANCE SHEETS – AVERAGE RATES AND YIELDS
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Interest rate risk management focuses on maintaining consistent growth in net interest income within Board-approved policy limits. The Company mainly uses earnings simulation models to analyze net interest sensitivity to movement in interest rates. In the table below, management has estimated the potential effect that gradual rising and/or falling interest rates over a twelve month period would have on the Company’s net interest income, given a static balance sheet.
During the third quarter of 2003, low interest rate levels coupled with a continued sluggish economy continued to constrain business loan growth. While consumer lending did show growth, it was more than offset by a reduction in the average balance of business loans. The low rate environment also promoted record refinancings in the mortgage banking industry, which in turn resulted in faster principal prepayments in the Company’s mortgage-backed and CMO investment securities, requiring the Company to reinvest in lower yielding securities. These prepayment levels created increased premium amortization on these bonds that also reduced investment yields. Even with high levels of prepayments, average investment securities increased $93.4 million during the third quarter of 2003.
While the Federal Reserve lowered the federal funds rate target in June 2003 by 25 basis points, not all of this rate reduction could be passed on to deposit customers, since rates were already at historically low levels. During the third quarter of 2003, average deposits declined slightly but reflected a continued decline in certificate of deposit balances (decline of $193.8 million in quarterly average balances) offset by growth in money market and interest checking balances of $106.0 million. During the quarter, overnight and longer term debt balances increased $53.8 million mainly to support the increases in investments securities noted above.
The Company’s simulation models continue to show interest rate changes as having a relatively modest effect on net interest income, with less than 1% impact in the scenarios at September 30, 2003 in the table above. As of September 30, 2003, new simulation models and assumptions now reflect higher risks to the Company’s net interest income should rates rise more rapidly, as under the 200 basis point rising scenario. Under this scenario, a rapid increase in rates would enable large sections of the Company’s loan portfolio to re-price upward quickly. This, however, would be offset by the effects of a large investment securities portfolio which primarily has fixed rates and would not re-price with rate changes. Also under this scenario, given the current low rates being paid on deposits, the larger rate increase with this scenario would put greater pressure on the Company to raise deposit rates more rapidly, thus offsetting the positive effects of the loan re-pricing. The table above shows that under the 100 basis point rising scenario, net interest income is more positively impacted since under these assumptions, rates on deposits can be increased more gradually, thus allowing the re-pricing of sections of the loan portfolio to have a greater positive impact on net interest income. Under the 100 basis point falling rate scenario in the table above, lower rates are modeled to reduce loan interest directly, but because deposit rates are at such low levels, further reduction of rates on much of the Company’s non-maturity deposits would be limited. Accordingly, net interest income would decrease, as there would be limited offsets to the reduced loan interest.
For further discussion of the Company’s market risk, see Management’s Discussion and Analysis of Financial Condition and Results of Operations – Interest Rate Sensitivity included in the Company’s 2002 Annual Report on Form 10-K.
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An evaluation was performed under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2003. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. There were not any significant changes in the Company’s internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
(a) Exhibits:
(b) Reports on Form 8-K:
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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.
Date: November 14, 2003
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