SECURITIES AND EXCHANGE COMMISSION
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FORM 10-Q
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).Yes X No
As of July 30, 2004, the registrant had outstanding 66,443,377 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
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
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 and six month periods ended June 30, 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.
The following is a summary of the allowance for loan losses.
Investment securities, at fair value, consist of the following at June 30, 2004 and December 31, 2003.
Equity securities include short-term investments in money market mutual funds of $136,273,000 at June 30, 2004 and $142,659,000 at December 31, 2003.
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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 $433,000 and $449,000, respectively, for the three month periods ended June 30, 2004 and 2003, and $869,000 and $899,000 for the six month periods ended June 30, 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 June 30, 2004, a liability in the amount of $4,516,000, 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 $342,877,000 at June 30, 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 $15,171,000 at June 30, 2004. At June 30, 2004, the Company had a recorded liability of $4,145,000 in principal and accrued interest to date, representing amounts owed to the security holders.
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The amount of net pension cost 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.
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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.
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
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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. At June 30, 2004, the Company had interest rate swaps with a total notional amount of $25,942,000, of which two swaps with a notional amount of $12,911,000 were 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.
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 was effective for loan commitments accounted for as derivatives and entered into on or after April 1, 2004, at which time the Company began excluding these expected cash flows in its determination of fair value. The effect of the change was a $227,000 reduction of pre-tax income, which was recorded in the second quarter of 2004.
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 and
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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
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 June 30, 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
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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 the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations.
Selected Financial Data
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Results of Operations
For the quarter ended June 30, 2004, net income amounted to $53.8 million, an increase of $3.4 million, or 6.6%, over the second quarter of the previous year. Return on assets was 1.51% and the return on equity totaled 14.91%. For the quarter, the efficiency ratio amounted to 57.96%. The increase in net income over the second quarter of last year was the result of a 14.4% increase in non-interest income coupled with a decrease in provision for loan losses of 37.2%, and partly offset by a higher effective income tax rate. Non-interest expense grew less than 3% and net interest income was down approximately 2%. Diluted earnings per share was $.79, an increase of 9.7% over $.72 per share in the second quarter of 2003.
Net income for the first six months of 2004 was $105.2 million, a $7.4 million, or 7.6%, increase over the first six months of 2003. Diluted earnings per share increased 11.6% to $1.54, compared to $1.38 for the first six months of last year. The increase in net income was primarily due to a 14.8% rise in non-interest income and a 17.4% decline in the provision for loan losses, partly offset by a higher effective income tax rate. In addition, net interest income declined slightly and non-interest expense was stable.
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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 second quarter of 2004 totaled $126.5 million, a 1.7% decrease from the second quarter of 2003. The decline in net interest income was mainly the result of lower interest income earned on both loans and investment securities. The reduction in total interest income exceeded the decrease in total interest expense. As a result, the net interest rate margin was 3.85% for the second quarter of 2004, compared to 4.15% in the second quarter of 2003 and 3.78% in the first quarter of 2004. For the first six months of 2004, net interest income totaled $249.4 million, a decrease of $3.5 million, or 1.4%, compared with the first six months of the previous year. The net interest rate margin declined 35 basis points to 3.82% during the first six months of 2004.
Total interest income decreased $7.2 million, or 4.5%, from the second quarter of 2003. The decrease was the result of lower interest earned on loans and investment securities. Rates earned on loans declined 35 basis points and rates earned on investment securities declined 64 basis points. The decrease in loan interest income was mainly the result of lower rates earned on virtually all lending products, but was offset by volume growth in the consumer lending area. Business loan volumes continued to be lower than the previous year, and this also factored in the reduction of interest income. While interest income on invest-
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Compared to the first six months of 2003, total interest income decreased $14.0 million. The decline reflects similar trends as noted in the quarterly comparison above, with lower average overall rates earned on interest earning assets, which occurred because of a declining rate environment in the last several years. The decline was partly offset by higher balances in investment securities and in consumer and real estate loans. Average tax equivalent yields on total interest earning assets for the six months were 4.60% in 2004 and 5.19% in 2003.
Total interest expense decreased $5.0 million, or 16.1%, compared to the second quarter of 2003. This decline was mainly the result of lower rates paid on all deposit products, but especially on money market and certificate of deposit balances. Rates on overnight borrowings also declined. Also, average retail certificate of deposit balances were lower, thus reducing interest expense, mainly due to the continued run-off of these balances. However, average balances of long-term jumbo certificates of deposit grew, as did short-term borrowings, and this liquidity was used to provide funding for the growth in the Company’s investment securities portfolio. Average rates paid on all interest bearing liabilities decreased from 1.14% in the second quarter of 2003 to .91% in the second quarter of 2004.
For the first six months of 2004, total interest expense decreased $10.6 million, or 16.9%, compared with the previous year. Most of the decline resulted from a 28 basis point reduction in average rates paid on deposit balances. Also contributing to the decline were lower rates paid on borrowings and lower average balances in retail certificates of deposit, partly offset by higher borrowings. Average balances of federal funds purchased and securities sold under agreements to repurchase increased by $515.3 million and were used mainly to fund investment securities purchases and loan growth. The overall average cost of total interest bearing liabilities was .91% for the first six months of 2004 compared to 1.17% for the same period in 2003.
Summaries of average assets and liabilities and the corresponding average rates earned/paid appear on the last page of this discussion.
Non-Interest Income
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For the second quarter of 2004, total non-interest income amounted to $84.3 million compared with $73.7 million in the same quarter last year, or an increase of 14.4%. This increase resulted from growth in deposit account, bank card and trust fee income, coupled with an increase in gains on sales of student loans. Deposit account fees in the second quarter of 2004 grew by 21.2% over the same quarter last year as a result of a 43.6% increase in overdraft fees (mainly due to pricing increases). Bank card fees for the quarter increased 11.4% over the same period last year, due mainly to higher fees earned on merchant and credit card transactions, both of which grew by more than 16%. Trust fees for the quarter were up 7.0% over the same period last year as the result of higher fees on personal and institutional trust accounts. Bond trading account and mortgage banking revenues declined from amounts recorded in the same period last year due to slowing business as interest rates have begun to rise. Compared with the same period last year, bond trading account revenues decreased $596 thousand due to lower demand by business and correspondent bank customers, while the decline in mortgage banking revenue of $1.3 million was due to lower personal mortgage loan originations. Other non-interest income in the second quarter of 2004 included a gain of $1.1 million on the sale of a bank branch. In addition, gains of $4.1 million on sales of $113.0 million of student loans were recorded in the second quarter of 2004, compared to gains of $101 thousand in the second quarter of 2003.
Non-interest income for the six months ended June 30, 2004 increased $22.0 million, or 14.8%, over the first six months of 2003. Deposit account fees rose $9.2 million, or 20.0%, due to growth of 41.5% in fee income on overdraft and return items. Compared to the previous year, bank card fee income rose $3.7 million, or 12.0%, mainly due to growth of $2.3 million in merchant fees and $1.8 million in cardholder fees. Trust fees increased $2.7 million, or 9.1%, over the same period last year as a result of growth in personal and institutional trust accounts, along with rising account valuations upon which fees are based. Other non-interest income increased $1.9 million in 2004 compared to the previous year, mainly due to higher levels of student loan sales and the bank branch sale mentioned above. These increases to non-interest income were partly offset by declines of $1.2 million in bond trading revenue and $1.9 million in mortgage banking revenue.
During the current quarter, net securities gains amounted to $2.8 million compared with net securities gains of $2.2 million in the same period last year. On a year to date basis, such gains amounted to $11.8 million and $4.4 million for 2004 and 2003, respectively. Most of the 2004 gain resulted from sales of $152.8 million in inflation-indexed treasury securities and $26.2 million in mortgage-backed securities.
Non-Interest Expense
Non-interest expense for the quarter amounted to $120.9 million, an increase of $2.7 million, or 2.3%, compared with $118.2 million recorded in the second quarter of last year. Compared to the second quarter of last year, data processing costs grew $1.9 million, or 19.3%, mainly as a result of higher software expense and bank card processing fees. Increased costs were also incurred for marketing and occupancy, which rose $467 thousand and $395 thousand, respectively. Occupancy expense increased mainly due to higher net rent expense, partly offset by lower building services expense. Other non-interest expense increased 6.2% over the same quarter last year, primarily due to higher loan collection expense and lower
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Non-interest expense rose $899 thousand, or .4%, over the first six months of 2003. Data processing costs increased $2.7 million, or 13.5%, due to higher software expense and bank card processing fees, while marketing expense increased $1.1 million, or 15.1%, mainly due to higher deposit promotional costs. Salaries and benefits decreased $887 thousand, or .7%, due to a decline in incentive payments and a reduction in pension plan expense. Equipment costs declined 4.6% due to reductions in depreciation, rental, and repair expense. Supplies and communication expense decreased 3.9% from the prior year mainly due to lower postage and courier expense and lower telephone and network expense. Other non-interest expense decreased 3.4% due to decreases in professional fees, operating losses and operating lease depreciation, partly offset by a decrease in capitalized loan costs.
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 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 consider various assumptions and exercise 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 for the second quarter of 2004 amounted to $6.2 million compared with $12.4 million in the first quarter of 2004 and $9.5 million in the second quarter of last year. The ratio of annualized net loan charge-offs to total average loans in the current quarter was .31% compared with .47% in the same quarter last year and .61% in the first quarter of this year. The decrease in net charge-offs in the current
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For the second quarter of 2004, annualized net charge-offs on average credit card loans increased slightly to 3.64%, compared with 3.59% in the second quarter of last year. Personal banking loan charge-offs decreased in the current quarter, with a charge-off ratio of .27% compared to .35% in the same quarterly period last year, as delinquencies remained at low levels.
Net charge-offs during the first six months of 2004 amounted to $18.6 million, compared to $18.4 million in the comparable prior period. Net charge-offs increased in the business, credit card, and real estate loan categories, with partly offsetting declines in personal banking and overdraft categories. The annualized net charge-off ratios were .46% in both the 2004 and 2003 six month periods.
The provision for loan losses for the current quarter totaled $6.3 million, and was down $4.0 million from the provision recorded in the first quarter of this year, and also down $3.7 million from the amount recorded in the second quarter of 2003. The provision was $16.5 million in the first six months of 2004 compared to $20.0 million in the same period in 2003. The allowance for loan losses at June 30, 2004 was $133.1 million, or 1.64% of total loans, and represented 481% of total non-performing loans. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at June 30, 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 June 30, 2004 totaled $27.7 million, a decrease of $4.9 million from amounts recorded at December 31, 2003. Most of the decrease occurred in lease-related non-accrual loans, which declined $4.2 million from year end. Lease-related loans comprised 30.1% of the June 30, 2004 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 $16.5 million as of June 30, 2004, and decreased $4.4 million since December 31, 2003. The decline in past due loans occurred mainly due to a decrease of $4.9 million in the personal real estate loan category, partly offset by an increase of $2.4 million in the business and business real estate loan categories.
Income Taxes
The effective tax rate for the Company was 35.5% for the second quarter of 2004, compared with an effective tax rate of 35.7% in the first quarter of 2004 and 31.9% in the second quarter of 2003. The effective tax rate was 35.6% for the first six months of 2004, compared to 31.3% for the comparable period in 2003. As reported in the Company’s previously filed Quarterly Report on Form 10-Q and Annual Report on Form 10-K, the lower effective tax rates in the prior year resulted from the recognition of tax benefits
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Financial Condition
Balance Sheet
Total assets of the Company were $14.4 billion at June 30, 2004 compared to $14.3 billion at December 31, 2003. Earning assets at June 30, 2004 were $13.1 billion and consisted of 62% loans and 37% investment securities, compared to $13.3 billion at December 31, 2003.
During the first six months of 2004, total period end loans decreased $34.8 million, or .4%, compared with balances at December 31, 2003. The decline was the result of decreases of $50.6 million in business real estate loans and $49.6 million in business loans, offset by increases of $27.3 million in construction loans and $2.5 million in personal real estate loans. Also, an increase of $20.3 million in personal banking loans was the result of growth in installment and home equity loans, partly offset by scheduled sales of student loans during the first six months of the year. While period end business loans declined from amounts recorded at December 31, 2003, average business loans grew $31.5 million in the second quarter of 2004 over the first quarter of 2004, reflecting higher line of credit usage and new lending relationships. Business real estate loans declined, on average, $30.3 million in the second quarter compared to the first quarter mainly due to scheduled payments on several large loans. While personal real estate loans grew slightly, new loan originations grew steadily since February due to continued low interest rates and seasonal increases. The increase in installment loans was mainly the result of increased lending initiatives in the areas of marine and recreational vehicles, and continued growth in home equity loans was reflective of the continued promotion of this product.
Available for sale investment securities, excluding fair value adjustments, decreased $78.1 million, or 1.6%, at June 30, 2004 compared to December 31, 2003. The decrease was due to principal paydowns of $408.5 million on mortgage-backed and asset-backed securities, maturities of $390.7 million and sales of $179.0 million, offset by purchases during the six months of 2004 of $933.0 million. The purchases of investment securities, which were funded mainly by increases in federal funds purchased, consisted primarily of asset-backed securities ($410.1 million) and U.S. government agency securities ($346.9 million).
Total deposits increased by $164.5 million, or 1.6%, at June 30, 2004 compared to December 31, 2003. The increase was due mainly to increases of $168.1 million in certificates of deposit of $100,000 and over, $32.9 million in money market accounts, and $28.8 million in savings accounts. This growth was offset by a decline of $60.4 million in certificates of deposit of less than $100,000.
Compared to 2003 year end balances, total borrowings at June 30, 2004 increased $41.3 million. This increase was due to increases in federal funds purchased of $247.5 million, offset by a decrease in repurchase agreements of $196.0 million. The increase in federal funds purchased provided liquidity for purchases of investment securities.
Liquidity and Capital Resources
Liquidity Management
The Company’s most liquid assets are comprised of investments in federal funds sold, securities purchased under agreements to resell (resale agreements), and available for sale marketable securities. Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The available for sale investment portfolio includes maturities of over $980 million which are scheduled over 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
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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 June 30, 2004, such deposits totaled $7.9 billion and represented nearly 76% 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 are normally considered more volatile and higher costing. These accounts totaled $847.3 million at June 30, 2004, comprising just 8.2% of total deposits.
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 on an overnight basis. 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 advances from the FHLB. The FHLB 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
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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 $289.7 million in loans and $804.2 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 as shown in the accompanying consolidated statements of cash flows. The Company’s cash and cash equivalents (defined as “Cash and due from banks” on the accompanying balance sheets) were $860.2 million at June 30, 2004, an increase of $293.1 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 $129.8 million during the first six months of 2004. 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, provided total cash of $32.8 million. Most of the cash inflow was due to $1.0 billion in sales and maturities of investment securities, partly offset by purchases of $938.2 million. Financing activities provided cash of $130.5 million, resulting from a $188.5 million increase in deposits and $51.5 million in additional overnight borrowings. These cash inflows were partly offset by $75.8 million required by the Company’s treasury stock repurchase program and cash dividend payments of $30.8 million. Future short-term liquidity needs arising from daily operations are not expected to vary significantly, and the Company believes it will be able to meet these cash flow needs.
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Capital Management
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 is shown below.
The Company 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 current quarter, the Company purchased approximately 759 thousand shares of treasury stock at an average cost of $45.22 per share. At June 30, 2004, nearly 1.5 million shares were available for purchase by the Company under its current authorization.
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 per share cash dividend by 7% in the first quarter of 2004 compared to the fourth quarter of 2003, and maintained the same dividend payout in the second quarter of 2004. The year 2004 represents the 36th consecutive year of per share dividend increases.
Commitments and Off-Balance Sheet Arrangements
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 June 30, 2004 totaled $5.7 billion (including approximately $2.6 billion in unused approved credit card lines). In addition, the Company enters into standby and commercial letters of credit. These contracts amounted to $342.9 million and $37.0 million, respectively, at June 30, 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 $4.5 million at June 30, 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.
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.
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Segment Results
The table below is a summary of segment results for the first six months of 2004 and 2003. Please refer to Note 9 in the notes to the consolidated financial statements for additional information about the Company’s operating segments.
For the six months ended June 30, 2004, income before income taxes for the Consumer segment increased $13.2 million, or 26.1%, mainly due to higher net interest income (including allocated credit for funds provided) and lower assigned loan loss costs, coupled with a 15.5% increase in non-interest income. The increase in non-interest income resulted mainly from higher overdraft fees. Also, non-interest expense grew only 1.7% over the previous year mainly due to lower corporate overhead allocations. For the six months ended June 30, 2004, income before income taxes for the Commercial segment was lower by 9.4%, mainly as a result of higher assigned loan loss costs and higher non-interest expense. A large commercial loan charge-off of $6.0 million in the first quarter of 2004 contributed to the higher loan loss costs. Non-interest income increased by 10.4% over the previous year mainly as a result of higher cash management fees coupled with an increase in corporate bank card transaction fee income. The increase in non-interest expense resulted from higher assigned costs for check processing and other internally allocated overhead costs. Money Management segment pre-tax profitability for the first six months of 2004 was up 26.0% over the previous year mainly due to higher overall revenues coupled with lower non-interest expense, which was down 6.4%. The reduction in expense was mainly due to lower salaries costs, which resulted mainly from a staffing reduction in the trust administration area as part of a department restructuring. Higher trust fees resulted in the higher overall trust revenue totals.
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.
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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’s adoption of SAB 105 effective April 1, 2004 resulted in the recognition of a pre-tax loss of $227 thousand.
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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 six months of 2004. As currently projected, a 200 basis point rising rate scenario would cause net interest income to decline $9.3 million or 1.94%, which is comparable to the amount reported at March 31, 2004. Under a scenario whereby rates increase 100 basis points, it is projected that net interest income would decline by $5.1 million, or 1.06%, compared with a decline of $3.3 million in the previous quarter’s projection. Under current projections, the Company’s exposure to declining rates was further reduced during the quarter such that a 100 basis point decline in rates would cause net interest income to increase by $2.7 million.
During the quarter, average loans declined $36.0 million from the previous quarter mainly as a result of the sales of $113.0 million in student loans, most of which occurred early in the quarter. Growth in business loans was offset by a decline in business real estate lending, but installment and home equity loans grew by a combined $47 million. The Company’s average investment securities portfolio increased by $112.9 million during the second quarter 2004 due mainly to asset-backed securities purchases occurring early in the quarter. However, the Company then began limiting the purchases of new securities, allowing normal maturities and pay-downs to reduce the overall portfolio. At June 30, 2004, total period end investment securities were $4.9 billion, a decline of $530.5 million from the balance at March 31, 2004. During the second quarter of 2004, average deposits increased by $180.5 million as a result of growth in both non-interest bearing deposits and other interest bearing non-maturity deposits. The result of lower investment securities balances towards the end of the quarter, coupled with higher average deposits and limited loan growth, allowed the Company’s short-term borrowings to decrease in the latter half of the second quarter. This decrease is expected to extend into the third quarter as well. Also, in June, the Federal Reserve raised its target federal funds rate by 25 basis points, beginning what most economists believe is the start of a rising rate environment, which could continue in the next few quarters.
As a result of these changes during the quarter, the Company made certain adjustments to its net interest income simulation models. Under the rising rate interest scenarios described above, projections of increases in rates on non-maturity deposits, coupled with the Company’s fixed rate investment portfolio, tend to offset the positive effects of the anticipated rate re-pricing of the loan portfolio. Also, lower levels of investment securities and lower short-term debt tends to reduce net interest income in the near term. A change in the mix of the balance sheet, in which maturities and re-payments of investment securities are reinvested into lending products, could however, improve the overall mix of earning assets and improve net interest income.
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.
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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 June 30, 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.
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.
The annual meeting of shareholders of the Company was held on April 21, 2004. The following proposals were submitted by the Board of Directors to a vote of security holders:
Other directors whose term of office as director continued after the meeting were: Giorgio Balzer, John R. Capps, W. Thomas Grant II, James B. Hebenstreit, David W. Kemper, Jonathan M. Kemper, Terry O. Meek, L.W. Stolzer, and Mary Ann Van Lokeren.
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(a) Exhibits:
See Index to Exhibits
(b) Reports on Form 8-K:
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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: August 4, 2004
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INDEX TO EXHIBITS
10.1 – Amended and Restated Commerce Bancshares, Inc. Restricted Stock Plan
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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