SECURITIES AND EXCHANGE COMMISSION
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FORM 10-Q
Commission File No. 0-2989
COMMERCE BANCSHARES, INC.
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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 May 3, 2004, the registrant had outstanding 67,237,082 shares of its $5 par value common stock, registrant’s only class of common stock.
Commerce Bancshares, Inc. and Subsidiaries
Form 10-Q
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PART I: FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
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CONSOLIDATED STATEMENTS OF INCOME
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
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CONSOLIDATED STATEMENTS OF CASH FLOWS
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Principles of Consolidation and Presentation
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 2003 data to conform to current year presentation. Results of operations for the three month period ended March 31, 2004 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 disclosed in the 2003 Annual Report on Form 10-K.
2. Allowance for Loan Losses
The following is a summary of the allowance for loan losses for the three months ended March 31, 2004 and 2003.
Investment securities, at fair value, consist of the following at March 31, 2004 and December 31, 2003.
Equity securities include short-term investments in money market mutual funds of $119,295,000 at March 31, 2004 and $142,659,000 at December 31, 2003.
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4. Intangible Assets
The following table presents information about the Company’s intangible assets which have estimable useful lives.
The Company does not have any intangible assets that are not currently being amortized. Aggregate amortization expense on intangible assets was $436,000 and $450,000, respectively, for the three month periods ended March 31, 2004 and 2003. Estimated annual amortization expense for the years 2004 through 2008 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 March 31, 2004, a liability in the amount of $4,868,000, representing the carrying value of the guarantee obligations associated with the standby letters of credit mentioned above, 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 $311,583,000 at March 31, 2004.
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 may be redeemed beginning in 2010. The maximum potential future payments guaranteed by the Company, which includes future interest and principal payments through maturity, was approximately $15,280,000 at March 31, 2004. At March 31, 2004, the Company had a recorded liability of $4,036,000 in principal and accrued interest to date, representing amounts owed to the security holders.
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The amount of net pension cost for the three months ended March 31, 2004 and 2003 is as follows:
The Company made a discretionary cash contribution of $6,000,000 to the pension plan in March 2004. The Company does not expect to contribute more than an additional $2,000,000 prior to the plan’s September 30 valuation date.
The shares used in the calculation of basic and diluted income per share are shown below.
The Company’s only component of other comprehensive income (loss) during the periods presented below was the unrealized holding gains and losses on available for sale securities.
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 among 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) by assets and liabilities based on their maturity, prepayment and/or repricing characteristics.
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 $27,454,000, of which two swaps with a notional amount of $13,045,000 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.
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The Company’s usage of derivative instruments is detailed below.
In March 2004, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments” (SAB 105). SAB 105 provides additional guidance in determining the fair market value of mortgage loan commitments. The new guidance prohibits the inclusion of the expected cash flows related to the associated servicing of the loan when determining the fair value of the loan commitment. This change in accounting tends to reduce the fair market value of the loan commitment and defers the income recognition resulting from the valuation of the commitment. SAB 105 is effective for loan commitments accounted for as derivatives and entered into on or after April 1, 2004, at which time the Company will begin excluding these expected cash flows in its determination of fair value. The Company does not believe that the effect of the change will be material to its financial statements.
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 2003 Annual Report on Form 10-K. Results of operations for the three month period ended March 31, 2004 are not necessarily indicative of results to be attained for any other period.
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, de-
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Critical Accounting Policies
The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, some of which require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments primarily by using internal cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company’s future financial condition and results of operations.
The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, pension accounting, and accounting for income taxes.
The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. 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 the allowance is provided in the Provision and Allowance for Loan Losses section of this discussion.
The Company, through its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $23.9 million at March 31, 2004. These private equity and venture capital securities are reported at estimated fair values in the absence of readily ascertainable fair values. 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 reasonably 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 other economic and market factors may affect the amounts that will ultimately be realized from these investments.
Management is required to make various assumptions in valuing its pension assets and liabilities. These assumptions include the expected rate of return on plan assets, the discount rate, and the rate of increase in future compensation levels. Changes to these assumptions could impact earnings in future periods. The Company takes into account the plan asset mix, funding obligations, and expert opinions in determining the various rates used to estimate pension expense. The Company considers the Moody’s AA corporate bond yields and other market interest rates in setting the appropriate discount rate. In addition, the Company reviews expected inflationary and merit increases to compensation in determining the rate of increase in future compensation levels.
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
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Selected Financial Data
Results of Operations
Summary
For the quarter ended March 31, 2004, net income amounted to $51.3 million, an increase of $4.1 million or 8.7% over the first quarter of the previous year. Return on assets was 1.45% and the return on equity totaled 14.1%. For the quarter, the efficiency ratio amounted to 59.2%. The increase in net income over the first quarter of last year was the result of a 15.2% increase in non-interest income, coupled with a decrease in non-interest expense of 1.5% compared to the same quarter last year. The provision for loan losses also grew by $230 thousand. Diluted earnings per share was $.75, an increase of 13.6% over $.66 per share in the first quarter of 2003.
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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 first quarter of 2004 was $123.0 million, a 1.0% decrease from the first quarter of 2003. The decline in net interest income was mainly the result of lower interest earned on investment securities and lower rates earned on business and personal banking loans. The net interest rate margin was 3.78% for the first quarter of 2004, compared to 4.19% in the first quarter of 2003 and 3.95% in the fourth quarter of 2003.
Total interest income decreased $6.8 million, or 4.4%, from the first quarter of 2003. The decrease was the result of a 51 basis point decline in rates earned on loans coupled with an 80 basis point decline on rates earned on investment securities, but was offset by higher average balances of loans and investment securities. Variable rate loans in the business, business real estate, and home equity line portfolios were mainly impacted. New purchases of investment securities at lower rates increased the average balance over the first quarter of 2003 by $854.2 million, increasing interest income but lowering securities yields. Lower rates on overnight investment balances also contributed to the decrease in interest income. The average tax equivalent yield on interest earning assets was 4.57% in the first quarter of 2004 compared to 5.24% in the first quarter of 2003.
Total interest expense decreased $5.6 million, or 17.8%, compared to the first quarter of 2003 due mainly to declines in average rates paid on interest bearing deposits, with the largest effects shown in the Company’s Premium Money Market deposit accounts as well as certificates of deposit under $100,000. Interest expense was also reduced by lower average rates paid on advances from the Federal Home Loan
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Summaries of average assets and liabilities and the corresponding average rates earned/paid appear on the last page of this discussion.
Non-Interest Income
For the first quarter of 2004, total non-interest income amounted to $86.0 million compared with $74.6 million in the same quarter last year, or an increase of 15.2%. This increase resulted from higher net securities gains and growth in deposit account, bank card and trust fees, but was offset by lower bond trading income and mortgage banking revenue. Deposit account fees in the first quarter of 2004 grew by 18.8% over the same quarter last year as a result of a 39.3% increase in overdraft fees (mainly due to pricing increases) and a 2.3% increase in commercial cash management revenues. Bank card fees for the quarter increased 12.7% over the same period last year, primarily resulting from a 34.7% increase in merchant interchange fees (mainly due to higher sales volumes upon which fees are based) and a 14.2% increase in credit cardholder fees, offset by slightly lower debit card transaction fees. Trust fees for the quarter also increased 11.3% compared to the same period last year as the result of growth in new accounts and higher trust account valuations upon which fees are charged. Compared with the same period last year, trading account fee income decreased 12.9% due to lower demand by business and correspondent bank customers. Mortgage banking revenue declined $543 thousand due to lower loan originations during the quarter, which resulted in fewer mortgage loan sales to the secondary market. Other non-interest income for the quarter included a pre-tax gain of $2.3 million on the sale of $63.0 million of student loans, which was lower than the gain of $4.1 million recorded in the same quarter last year.
During the current quarter, net securities gains amounted to $9.0 million compared with net securities gains of $2.3 million in the same period last year, and resulted mainly from sales of $115.3 million in inflation-indexed treasury securities and $26.2 million in mortgage-backed securities.
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Non-Interest Expense
Non-interest expense for the quarter amounted to $118.9 million, a decrease of $1.8 million, or 1.5%, compared with $120.7 million recorded in the first quarter of last year.
Compared with the first quarter of last year, salaries and benefits expense decreased as a result of lower incentive payments, a reduction in temporary and contract labor and lower costs for the Company’s pension plan. Full-time equivalent employees totaled 4,847 and 5,013 at March 31, 2004 and 2003, respectively. Costs also declined for occupancy, equipment, and communication, while marketing and software costs both increased modestly. Occupancy expense decreased mainly due to lower rent and snow removal expense. Supplies and communication expense decreased 7.0% during the quarter mainly due to lower postage and courier expense and lower telephone and network expense. Data processing and software increased mainly due to higher costs for software maintenance contracts and software amortization costs. Other non-interest expense decreased $1.8 million, or 12.9%, from the same quarter last year primarily due to decreases in operating losses and charitable contributions.
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. This process to determine reserves uses such tools as the Company’s “watch loan list” 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
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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 outside regulators.
Net loan charge-offs were $12.4 million in the first three months of 2004, a $3.4 million increase over the same period in the prior year. Total net charge-offs for the first three months of 2004 were .61% of total average loans, compared to .42% in the fourth quarter of 2003, and .46% for the first quarter in 2003. The increase in net loan charge-offs compared to first quarter 2003 resulted principally from the charge-off of $6.0 million on a single business loan and from higher net charge-offs on business real estate loans and credit card loans, partially offset by lower net charge-offs on personal banking loans. Compared to the fourth quarter of 2003, net charge-offs were up this quarter due to the business loan charge-off mentioned above.
The loan charge-off of $6.0 million resulted from the borrower filing bankruptcy during the current quarter. The remaining portion of this loan totaled $5.3 million and was placed on non-accrual status this quarter.
For the first quarter of 2004, net charge-offs on average credit card loans amounted to 3.60% compared with 3.97% in the fourth quarter of 2003 and 3.69% in the first quarter of 2003. Personal banking loan net charge-offs amounted to .42% of average personal banking loans this quarter compared to .53% in the fourth quarter of 2003 and .56% in the first quarter of 2003.
The provision for loan losses was $10.3 million in the first three months of 2004, compared to $10.0 million in the same period in 2003, and $11.0 million in the fourth quarter of 2003. The allowance for loan losses at March 31, 2004 was $133.1 million, or 1.63% of average loans during the quarter, and represented 400% of total non-performing loans. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at March 31, 2004.
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 management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Loans that are 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are 1-4 family first mortgage loans or consumer loans that are exempt under regulatory rules from being classified as non-accrual.
Non-accrual loans at March 31, 2004 totaled $33.3 million, an increase of $769 thousand over amounts recorded at December 31, 2003. This increase includes the $5.3 million business loan mentioned above, partly offset by other declines in non-accrual loans. Lease-related loans comprise 27.1% of the March 31,
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Income Taxes
The effective tax rate for the Company was 35.7% for the first quarter of 2004, compared with 29.3% in the fourth quarter of 2003 and 30.6% in the first quarter of 2003. As reported in the 2003 Annual Report on Form 10-K, the lower effective tax rates in the previous quarters resulted from the recognition of tax benefits recorded from various corporate reorganization initiatives. Additional tax benefits related to these initiatives will not be recognized in income until certain conditions are satisfied. It is projected that such conditions may be resolved as early as the third quarter of 2004 relating to approximately $18.9 million of the remaining benefits.
Financial Condition
Total assets of the Company were $14.5 billion at March 31, 2004 compared to $14.3 billion at December 31, 2003. Earning assets at March 31, 2004 were $13.6 billion, consisting of 60% loans and 40% investments.
During the first quarter of 2004, average loans increased $128.9 million or 1.6% compared with the previous quarter, and were up $181.0 million or 2.3% compared to the same period last year. Compared to the fourth quarter of 2003, average business, construction, business real estate, personal banking and credit card loans grew by $48.5 million, $15.9 million, $11.0 million, $38.1 million and $13.6 million, respectively. As a result of lower levels of mortgage loan originations during the quarter, personal real estate loans declined by $5.0 million. Moderate growth in the economy during the current quarter helped increase loan demand for business and construction loans which grew a combined total of over $64 million. Business real estate loans continued to show modest growth, aided by the low interest rate environment. The increase in personal banking loans was the result of continued growth in home equity loans and growth in seasonal student loan activity.
Available for sale investment securities, excluding fair value adjustments, increased on average $163.3 million, or 3.5%, this quarter compared with the previous quarter; however, since December 31, 2003, the portfolio has increased $350.6 million. During the current quarter, principal prepayments received on mortgage and asset-backed securities continued to slow to $195.2 million, down from $256.3 million in the previous quarter, reflecting lower mortgage refinancing activities affecting the industry. This reduction, combined with scheduled maturities of $163.8 million and investment securities sales of $141.5 million, lowered the portfolio by $500.5 million. New purchases of investment securities during the current quarter totaled $827.9 million, and consisted mainly of U.S. government and agency ($346.9 million), mortgage-backed ($164.1 million) and asset-backed securities ($307.5 million). The sale of investment securities in the current quarter was mainly the result of the Company’s review of its portfolio and adjustment for such things as concentration, duration, interest rate risk, potential gains and other factors.
Total average deposits grew by $100.2 million, or 1.0% (4% annualized growth), during the first quarter of 2004 compared to the fourth quarter of last year, and were up 3.1% compared to the same period last year. The increase over the fourth quarter of last year was the result of growth in certificates of deposit of $100,000 and over ($110.9 million), non-interest bearing demand deposits ($50.0 million), and interest checking ($46.9 million). This growth was offset by declines in money market deposits ($71.5 million) and certificates of deposit of less than $100,000 ($40.4 million).
During the first quarter of 2004, average borrowings increased $163.8 million over the previous quarter, primarily due to growth in federal funds purchased of $271.6 million, offset by a decrease in repurchase agreements of $137.4 million.
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Liquidity and Capital Resources
Liquidity Management
The Company’s most liquid assets are comprised of available for sale marketable investment securities, federal funds sold, and securities purchased under agreements to resell (resale agreements). Federal funds sold and resale agreements totaled $71.6 million at March 31, 2004. These investments normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $5.3 billion at March 31, 2004. The portfolio includes maturities of over $920 million which come due during the next 12 months, which offer substantial resources to meet either new loan demand or reductions in the Company’s deposit funding base. The Company pledges portions of its investment securities portfolio to secure public fund deposits, securities sold under agreements to repurchase, and borrowing capacity at the Federal Reserve. Total investment securities pledged for these purposes comprised 37% of the total investment portfolio at March 31, 2004.
Liquidity is also available from the Company’s large base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At March 31, 2004, such deposits totaled $7.7 billion and represented over 75% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time open and certificates of deposit of $100,000 and over totaled $814.6 million at March 31, 2004. These accounts are normally considered more volatile and higher costing, but comprise just 7.9% of total deposits at March 31, 2004.
Another important component of liquidity is the level of borrowings from third party sources, and the availability of future credit. The Company’s outside borrowings are comprised of federal funds purchased, securities sold under agreements to repurchase, and longer-term debt.
Federal funds purchased and securities sold under agreements to repurchase are generally borrowed overnight, and amounted to $2.1 billion at March 31, 2004. Federal funds purchased are obtained mainly from upstream correspondent banks with whom the Company maintains approved lines of credit, while securities sold under agreements to repurchase are comprised of non-insured customer funds secured by a portion of the Company’s investment portfolio.
The Company’s long-term debt is relatively small compared to the Company’s overall liability position. It is comprised mainly of borrowings from the FHLB, which totaled $467.0 million at March 31, 2004. These borrowings were a combination of fixed and floating rates with maturities of generally less than four years. Other outstanding long-term borrowings relate to the Company’s leasing and venture capital operations and amounted to $27.1 million at March 31, 2004.
In addition to those mentioned above, several other sources of liquidity are available. The Company believes that its sound debt ratings from Standard & Poor’s and Moody’s would enable its commercial paper to be readily marketable should the need arise. No commercial paper has been issued or outstanding during the past five years. In addition, the Company has temporary borrowing capacity at the Federal Reserve discount window, for which it has pledged $290.7 million in loans and $138.8 million in investment securities. Also, because of its lack of significant long-term debt, the Company believes that it could generate additional liquidity through its Capital Markets Group from sources such as large, jumbo certificates of deposit. Future financing could also include the issuance of common or preferred stock.
The following discussion is based on cash flow amounts which 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 $409.9 million at March 31, 2004, a decrease of $157.2 million compared to December 31, 2003. The cash flow provided by operating activities is considered a very stable source of funds and consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $83.1 million during the current quarter. Investing activities, consisting mainly of purchases and maturities of available for sale securities, changes in levels of overnight investments in federal funds sold and resale agreements, and changes in the level of the loan portfolio, used total cash of $293.6 million. Most of the cash outflow was due to $832.6 million in purchases of
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The Company maintains strong regulatory capital ratios, including those of its principal banking subsidiaries, which exceed the well-capitalized guidelines under federal banking regulations. Information about the Company’s risk-based capital at the end of the last two fiscal quarters is shown below:
Commerce maintains a treasury stock buyback program; and in January 2004 was authorized by the Board of Directors to repurchase up to 3 million shares of its common stock. The Company has routinely used these shares to fund the Company’s annual 5% stock dividend and various employee benefit programs. During the quarter ended March 31, 2004 the Company purchased approximately 840 thousand shares of treasury stock at an average cost of $49.27 per share.
The Company’s common stock dividend policy reflects its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, and alternative investment options. The Company increased its cash dividend by 7% in the first quarter of 2004 compared to the fourth quarter of 2003, making 2004 the 36th consecutive year of per share dividend increases.
Various commitments and contingent liabilities arise in the normal course of business which are not required to be recorded on the balance sheet. The most significant of these are loan commitments, which at March 31, 2004 totaled $6.0 billion (including approximately $3.0 billion in unused approved credit card lines). In addition, the Company enters into standby and commercial letters of credit. These contracts amounted to $311.6 million and $31.6 million, respectively, at March 31, 2004. Since many commitments expire unused or only partially used, these totals do not necessarily reflect future cash requirements. The carrying value of the guarantee obligations associated with the standby letters of credit, which has been recorded as a liability on the balance sheet, amounted to $4.9 million at March 31, 2004. Management does not anticipate any material losses arising from commitments and contingent liabilities and believes there are no material commitments to extend credit that represent risks of an unusual nature.
In March 2004, the Company contributed $6.0 million to its pension plan. This contribution represented the latest discretionary contribution from the Company over the last several years in order to mitigate the effect of declining returns and valuation on the pension fund assets along with growing pension obligations. The contribution had no significant effect on the Company’s overall liquidity. The minimum required contribution for 2004 is expected to be zero. The Company does not expect to contribute more than an additional $2.0 million prior to the pension fund’s annual measurement date of September 30.
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The Company has additional funding commitments arising from investments in several private equity concerns, classified as non-marketable investment securities, and low-income housing partnerships. These unfunded commitments are not significant to the Company’s liquidity position.
Impact of Recently Issued Accounting Standards
The Financial Accounting Standards Board (FASB) issued Interpretation No. 46R (FIN 46R), “Consolidation of Variable Interest Entities”, in December 2003. FIN 46R clarified the requirements 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. Public companies were required to apply the unmodified provisions of the Interpretation to “special-purpose entities” by the end of the first reporting period ending after December 15, 2003. Public companies, other than small business issuers, were required to apply the revised Interpretation by the end of the first reporting period beginning after December 15, 2003 to all entities that were not special-purpose entities.
As mentioned in the 2003 Annual Report on Form 10-K, 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 FIN 46R. In addition to the above, the FASB has elected to reconsider provisions of FIN 46R concerning SBIC related private equity investments and does not currently require these types of investments to be consolidated. 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 Company does not have any other significant investments in unconsolidated entities meeting the requirements of FIN 46R.
In March 2004, the Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments” (SAB 105). SAB 105 provides recognition guidance for entities that issue loan commitments that are required to be accounted for as derivative instruments, as is discussed further in Note 10 to the consolidated financial statements. The Company will adopt SAB 105 effective April 1, 2004 and does not expect that the adoption will have a material impact on its 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 primarily uses earnings simulation models to analyze net interest sensitivity to movement in interest rates. The table below shows the 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.
The table shown above reflects somewhat greater exposure of the Company’s net interest income to rising rates during the first quarter of 2004. Under a 200 basis point rising rate scenario, net interest income is expected to decline $9.6 million or 1.96%, while under a 100 basis point increase, net interest income is expected to decline by $3.3 million or .67%. The Company’s exposure to declining rates was reduced somewhat during the quarter such that a 100 basis point decline in rates would negatively impact net interest income by a small amount.
During the quarter, the Company’s average investment securities portfolio increased by $159.5 million with most of the increase the result of the acquiring fixed rate agency and asset-backed securities. Also during the quarter, the Company sold $115.3 million of inflation-indexed treasury securities. The sale of these bonds, which had a variable inflation component, combined with the acquisition of additional fixed rate securities, made the overall mix of the investment portfolio more fixed rate in nature. Average loans also increased by $128.9 million, mainly in the areas of business and personal banking loans. The overall increase in loans did not materially impact the interest rate risk position of the Company, as the growth included elements of both fixed and variably priced loans. At the same time, partly in response to loan growth and partly to help fund the added investment securities, the Company increased average federal funds purchased, whose rates fluctuate daily, by $271.6 million, and added $100.0 million in variable rate borrowings from the FHLB.
As a result of these changes during the quarter, under the rising rate interest scenarios described above, the higher level of variably based borrowings tends to increase interest expense in conjunction with the anticipated rise in short-term rates, while the larger investment portfolio with greater fixed rate characteristics will re-price only with principal maturities. These two factors were mainly responsible for the Company’s overall increased risk to rising interest rates.
The Company performs monthly simulations modeling interest rate risk in accordance with changes to its balance sheet composition. For further discussion of the Company’s market risk, see the Interest Rate Sensitivity section of Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations included in the Company’s 2003 Annual Report on Form 10-K.
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 March 31, 2004. 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.
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PART II: OTHER INFORMATION
The following table sets forth information about the Company’s purchases of its $5 par value common stock, its only class of stock registered pursuant to Section 12 of the Exchange Act.
On January 30, 2004, the Company announced that its Board of Directors had approved the additional purchase of up to 1,825,129 shares of Company common stock. This, coupled with the shares available under the prior authorization, provided the Company with authority to purchase 3,000,000 shares.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
See Index to Exhibits
(b) Reports on Form 8-K:
On January 14, 2004, the Registrant furnished its announcement of fourth quarter earnings for 2003. On February 13, 2004, the Registrant furnished an announcement of the purchase of 400,000 shares of its common stock from family limited partnerships that are associated with several former and current executive officers.
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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.
Date: May 7, 2004
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INDEX TO EXHIBITS
31.1 – Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 – Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 – Certification of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 – Certification of CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
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