SECURITIES AND EXCHANGE COMMISSION
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FORM 10-Q
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).Yes X No
As of November 1, 2004, the registrant had outstanding 66,053,858 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). The consolidated financial statements in this report have not been audited. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 2003 data to conform to current year presentation. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature, except for the income tax expense adjustment discussed below in Note 11. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results of operations for the full year or any other interim periods.
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.
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Investment securities, at fair value, consist of the following at September 30, 2004 and December 31, 2003.
Equity securities in the available for sale portfolio include short-term investments in money market mutual funds of $148,588,000 at September 30, 2004 and $142,659,000 at December 31, 2003. Non-marketable securities primarily include securities held for debt and regulatory purposes, which amounted to $51,670,000 and $51,644,000 at September 30, 2004 and December 31, 2003, respectively, in addition to venture capital and private equity investments, which amounted to $21,569,000 and $21,507,000 at the respective dates.
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 $431,000 and $453,000, respectively, for the three month periods ended September 30, 2004 and 2003, and $1,300,000 and $1,352,000 for the nine month periods ended September 30, 2004 and 2003. Estimated annual amortization expense for the years 2004 through 2008 is as follows.
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The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.
At September 30, 2004, a liability in the amount of $4,803,000, 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 $331,993,000 at September 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 $15,062,000 at September 30, 2004. At September 30, 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.
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 make any additional contributions during 2004.
On October 22, 2004, the Company’s Board of Directors approved a change to its employee benefits plans effective January 1, 2005. With this change, the benefits accrued under the Company’s defined benefit pension plan will be frozen and enhancements will be made to its employee 401k plan, thereby increasing contributions to this 401k plan. These changes are not expected to have a material effect on the Company’s financial statements.
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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 and assignment of overhead costs among segments. 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.
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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 September 30, 2004, the Company had interest rate swaps with a total notional amount of $24,481,000, of which two swaps with a notional amount of $12,774,000 were designated as fair value hedges of certain fixed rate loans. The remaining swaps are matching stand alone instruments, whose fair values offset each other with no impact to income. 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.
During the third quarter of 2004, the Company recognized income tax benefits totaling $13,960,000 associated with certain corporate tax reorganization initiatives. The overall effective income tax rate for the third quarter of 2004 was 17.2% compared with 35.4% in the second quarter of 2004 and 24.6% in the third quarter of 2003. For the nine months ended September 30, 2004 and 2003, income tax expense amounted to $71,150,000 and $62,416,000 and represented effective income tax rates of 29.8% and 29.0%, respectively. The Company will recognize an additional $4,950,000 tax benefit related to these initiatives in the fourth quarter of 2004, resulting in an annual effective tax rate of approximately 29%. The Company has additional income tax benefits totaling approximately $13,705,000 associated with other corporate reorganization activities, which will not be recognized into income until certain conditions are satisfied. It is projected that such conditions may be resolved as early as the third quarter of 2005.
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The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Company’s 2003 Annual Report on Form 10-K. Results of operations for the three and nine month periods ended September 30, 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, 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 esti-
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The Company, through its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $25.0 million at September 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 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 the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations.
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Selected Financial Data
Results of Operations
Summary
For the quarter ended September 30, 2004, net income amounted to $62.5 million, an increase of $7.6 million, or 13.8%, over the third quarter of the previous year. Return on assets was 1.78% and the return on equity totaled 17.41%. For the quarter, the efficiency ratio amounted to 59.22%. The increase in net income over the third quarter of last year was the result of a $4.9 million reduction in income tax expense coupled with growth in non-interest income of $2.0 million, and a $3.0 million reduction in the provision for loan losses. Compared to the third quarter of last year, non-interest expense increased 3.5%. Diluted earnings per share was $.93, an increase of 17.7% over $.79 per share in the third quarter of 2003.
Net income for the first nine months of 2004 was $167.7 million, a $15.0 million, or 9.8%, increase over the first nine months of 2003. Diluted earnings per share increased 13.8% to $2.47, compared to $2.17 for the first nine months of last year. The increase in net income was primarily due to a 10.6% rise in non-interest income and a 22.0% decline in the provision for loan losses, partly offset by growth in non-interest expense of 1.4% and a slight decline in net interest income. Income tax expense in 2004 increased
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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.
Net interest income for the third quarter of 2004 totaled $123.7 million, a 1.4% increase over the third quarter of 2003. The increase in net interest income was mainly the result of higher interest income earned on investment securities, coupled with lower deposit interest expense. These effects were partly offset by higher short-term borrowing costs and lower interest on loans. As a result, the net interest rate margin was 3.82% for the third quarter of 2004, compared to 3.89% in the third quarter of 2003 and 3.85% in the second quarter of 2004. For the first nine months of 2004, net interest income totaled $373.1 million, a decrease of $1.8 million, or .5%, compared with the first nine months of the previous year. The net interest rate margin declined 25 basis points to 3.82% during the first nine months of 2004 compared to the prior year.
Total interest income increased $3.1 million, or 2.1%, over the third quarter of 2003. The increase was the result of higher average balances of investment securities and loans, but partly offset by lower loan yields. Rates earned on loans declined 9 basis points and rates earned on investment securities increased
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Compared to the first nine months of 2003, total interest income decreased $10.9 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 the declining interest 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 nine months were 4.63% in 2004 and 5.03% in 2003.
Total interest expense increased $1.4 million, or 5.2%, compared to the third quarter of 2003. This increase was mainly the result of an increase in average borrowings of $85.5 million and an increase in average rates, especially on federal funds purchased, which increased 50 basis points over the same quarter last year. In addition, average rates paid were lower on most certificate of deposit balances, while rates paid on non-maturity deposits were only modestly higher. Average rates paid on interest bearing liabilities increased from .97% in the third quarter of 2003 to 1.00% in the third quarter of 2004.
For the first nine months of 2004, total interest expense decreased $9.2 million, or 10.3%, compared with the previous year. Most of the decline resulted from a 19 basis point reduction in average rates paid on deposit balances. Also contributing to the decline were lower average balances in retail certificates of deposit. These decreases were partly offset by higher borrowings. Average balances of federal funds purchased and securities sold under agreements to repurchase increased by $377.8 million and were used mainly to fund investment securities purchases primarily at the beginning of 2004 and loan growth. The overall average cost of total interest bearing liabilities was .94% for the first nine months of 2004 compared to 1.10% 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.
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Non-Interest Income
For the third quarter of 2004, total non-interest income amounted to $78.9 million compared with $76.9 million in the same quarter last year, or an increase of 2.6%. This increase resulted from growth in deposit account, bank card and trust fee income. Deposit account fees grew by 3.3% in the current quarter compared to the same quarter last year as a result of a 10.7% increase in overdraft fees (mainly due to pricing increases). Bank card fees rose 17.3% over the same period last year, due mainly to higher fees earned on merchant, debit card and credit card transactions, all of which grew by more than 10%. Trust fees for the quarter were up 3.9% over the same period last year as the result of higher fees on institutional trust accounts. Mortgage banking fee income declined $362 thousand from amounts recorded in the same period last year due to lower customer demand, and bond trading account revenues decreased $841 thousand due to lower demand by business and correspondent bank customers. Other non-interest income in the third quarter of 2004 included gains of $1.6 million on sales of student loans, compared to gains of $1.9 million in the third quarter of 2003. In addition, farm management fees declined $757 thousand due to the sale of the farm management business in the third quarter of 2003.
Non-interest income for the nine months ended September 30, 2004 increased $23.9 million, or 10.6%, over the first nine months of 2003. Deposit account fees rose $9.7 million, or 13.9%, due to growth of 29.0% in fee income on overdraft and return items. Compared to the previous year, bank card fee income rose $7.0 million, or 14.0%, with merchant fees and cardholder fees each growing $2.8 million, and debit card fees growing $809 thousand. Trust fees increased $3.3 million, or 7.3%, 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 $1.7 million in 2004 compared to the previous year, mainly due to higher levels of student loan sales during 2004 and a bank branch sale in the second quarter of 2004, partly offset by lower farm management fees mentioned above. These increases to non-interest income were partly offset by declines of $2.0 million in bond trading revenue and $2.3 million in mortgage banking revenue.
During the current quarter, net securities losses amounted to $148 thousand compared with net securities gains of $896 thousand in the same period last year. The net securities losses in the third quarter of 2004 included an impairment of $300 thousand recognized on a private equity investment held by a venture capital subsidiary, which was partly offset by gains on sales from the banks’ available for sale portfolio. On a year-to-date basis, securities transactions resulted in net gains of $11.6 million and $5.3 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.
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Non-Interest Expense
Non-interest expense for the quarter amounted to $120.5 million, an increase of $4.1 million, or 3.5%, compared with $116.4 million recorded in the third quarter of last year. Compared to the third quarter of last year, salaries and benefits expense increased slightly as a result of higher salaries and health care expense, partly offset by lower pension and incentive payments. Full-time equivalent employees totaled 4,821 and 4,986 at September 30, 2004 and 2003, respectively. Increased costs were also incurred for occupancy, supplies and communication and marketing which rose $289 thousand, $614 thousand and $616 thousand, respectively, over amounts recorded in the third quarter of last year. Data processing costs grew $1.2 million, or 11.3%, mainly as a result of higher software expense and bank card processing fees. Other non-interest expense increased 8.6% over the same quarter last year, primarily due to higher operating losses, professional fees and lower capitalized loan costs. Equipment expense decreased 3.7% during the quarter mainly due to lower depreciation on computer hardware and lower costs for maintenance contracts.
Non-interest expense increased $5.0 million, or 1.4%, over the first nine months of 2003. Data processing costs increased $3.8 million, or 12.7%, due to higher software expense and bank card processing fees, while marketing expense increased $1.7 million, or 15.3%, mainly due to higher deposit promotional costs. Occupancy expense increased mainly due to the sale of a bank facility earlier in the year, which resulted in lower outside tenant rent income and higher rent expense as the banking operations were moved to other leased facilities. Salaries and benefits decreased $374 thousand, or .2%, due to a decline in incentive payments, lower costs for temporary and contract labor, and lower pension plan expense. These decreases were partly offset by higher staff salaries and health care expense. Equipment costs declined 4.3% due to reductions in depreciation and maintenance expense. Other non-interest expense was held to a slight increase of .4% over the prior period due to lower capitalized loan costs and higher operating losses and loan collection expense. These increases were partly offset by lower professional fees and operating lease depreciation.
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Provision and Allowance for Loan Losses
The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. The Company combines estimates of the reserves needed for loans evaluated on an individual basis for impairment with estimates of the reserves needed for pools of loans with similar risk characteristics. 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 third quarter of 2004 amounted to $6.4 million compared with $6.2 million in the second quarter of 2004 and $9.7 million in the third quarter of last year. The ratio of annualized net loan charge-offs to total average loans in the current quarter was .31% compared with .48% in the same quarter last year and .31% in the second quarter of this year.
For the third quarter of 2004, annualized net charge-offs on average credit card loans decreased to 3.24%, compared with 3.66% in the third quarter of last year. Personal banking loan charge-offs decreased in the current quarter, with a charge-off ratio of .42% compared to .45% in the same quarterly period last year, as delinquencies remained at low levels.
Net charge-offs during the first nine months of 2004 amounted to $25.0 million, compared to $28.1 million in the comparable prior period. Net charge-offs decreased in the business, personal banking, overdraft, and real estate loan categories, with partly offsetting increases in credit card net charge offs. The annualized net charge-off ratio decreased to .41% compared to ..47% in the comparable prior period.
The provision for loan losses for the current quarter totaled $6.6 million, and was up $326 thousand from the provision recorded in the second quarter of this year, and down $3.0 million from the amount recorded in the third quarter of 2003. The provision was $23.1 million in the first nine months of 2004 compared to $29.7 million in the same period in 2003. The allowance for loan losses at September 30, 2004 was $133.4 million, or 1.63% of total loans, and represented 522% of total non-performing loans. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at September 30, 2004.
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Risk Elements of Loan Portfolio
The following table presents non-performing assets and loans which are past due 90 days and still accruing interest. Non-performing assets include non-accruing loans and foreclosed real estate. Loans are placed on non-accrual status when 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 September 30, 2004 totaled $25.6 million, a decrease of $7.0 million from amounts recorded at December 31, 2003. Most of the decrease occurred in lease-related non-accrual loans, which declined $4.8 million from year end. Lease-related loans comprised 30.3% of the September 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 $17.6 million as of September 30, 2004, and decreased $3.3 million since December 31, 2003. The decline occurred mainly in personal real estate loans ($5.1 million), student loans ($1.1 million) and credit card loans ($906 thousand), but was partly offset by a $3.6 million increase in business and business real estate loans.
Income Taxes
During the third quarter of 2004, income tax expense amounted to $13.0 million, a decrease of $4.9 million from the same period last year. The effective tax rate for the Company was 17.2% for the third quarter of 2004, compared with an effective tax rate of 24.6% in the third quarter of 2003 and 35.5% in the second quarter of 2004. The lower income tax expense in the third quarter of 2004 was the result of the recognition of tax benefits, totaling $14.0 million, associated with certain corporate tax reorganization initiatives. For the nine months ended September 30, 2004 and 2003, income tax expense amounted to $71.2 million and $62.4 million and represented effective income tax rates of 29.8% and 29.0%, respectively. The Company will recognize an additional $5.0 million tax benefit related to these initiatives in the fourth quarter of 2004, resulting in an annual effective tax rate of approximately 29%. The Company has additional income tax benefits totaling approximately $13.7 million associated with other corporate reorganization activities, which will not be recognized into income until certain conditions are satisfied. It is projected that such conditions may be resolved as early as the third quarter of 2005.
Financial Condition
Balance Sheet
Total assets of the Company were $14.1 billion at September 30, 2004 compared to $14.3 billion at December 31, 2003. Earning assets at September 30, 2004 were $13.2 billion and consisted of 62% loans and 37% investment securities, compared to $13.3 billion at December 31, 2003.
During the first nine months of 2004, total period end loans increased $20.2 million, or .2%, compared with balances at December 31, 2003. The increase was the result of increases of $59.3 million in consumer loans, primarily from increases in marine and recreational vehicle lending. Also, home equity and business loans grew by $47.0 million and $17.7 million, respectively. This growth was offset by decreases of
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While period end business loans have increased compared to 2003 year end balances, average business loans continued to decline ($44.4 million) during the third quarter of 2004 as compared to the previous quarter due to weak demand and lower line of credit usage.
Available for sale investment securities, excluding fair value adjustments, decreased $147.0 million, or 3.0%, at September 30, 2004 compared to December 31, 2003. The decrease was due to principal paydowns on mortgage and asset-backed securities of $635.2 million, maturities of securities of $501.6 million and sales of $188.6 million, offset by purchases during the nine months of 2004 of $1.2 billion. The purchases of investment securities, which were funded mainly by increases in federal funds purchased, consisted primarily of mortgage and asset-backed securities ($569.4 million) and U.S. government agency securities ($451.0 million).
Total deposits increased by $75.4 million, or .7%, at September 30, 2004 compared to December 31, 2003. The increase was due mainly to increases of $87.0 million in certificates of deposit of $100,000 and over, $34.7 million in money market accounts, and $18.7 million in savings accounts. This growth was offset by a decline of $75.8 million in certificates of deposit of less than $100,000.
Compared to 2003 year end balances, total borrowings at September 30, 2004 decreased $254.3 million. This decline was due to decreases in repurchase agreements of $529.1 million, offset by an increase in federal funds purchased of $286.1 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 $920 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 investment securities portfolio, primarily to secure public fund deposits, securities sold under agreements to repurchase, and borrowing capacity at the Federal Reserve. Total investment securities pledged for these and other regulatory and legal purposes comprised approximately 50% of the investment portfolio at September 30, 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 September 30, 2004, such deposits totaled $7.9 billion and represented 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
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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. Most of the advances outstanding at September 30, 2004 have a floating rate and mature within two years. Other outstanding long-term borrowings relate to the Company’s leasing and venture capital operations. Period end borrowings of the Company are shown below.
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 $293.1 million in loans and $742.5 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 or privately placed debt offerings. 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 $533.9 million at September 30, 2004, a decrease of $33.3 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 $196.9 million during the first nine 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 $61.9 million. Most of the cash inflow was due to $1.3 billion in sales and maturities
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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 stock buyback program; and in January 2004 was authorized by the Board of Directors to repurchase up to 3,000,000 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 752,000 shares of treasury stock at an average cost of $46.98 per share. At September 30, 2004, approximately 703,000 shares were available for purchase by the Company under the January 2004 authorization. On October 22, 2004, the Board of Directors authorized the Company to purchase 4,296,580 additional shares, bringing the total authorization up to 5,000,000 shares.
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 and third quarters of 2004. Overall cash dividends paid for the first nine months of 2004 have increased $9.4 million, or 25.7%, over amounts paid in the previous year. 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 September 30, 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 $332.0 million and $20.9 million, respectively, at September 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 $4.8 million at September 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 a discretionary contribution from the Company in order to better manage its future pension plan
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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.
Segment Results
The table below is a summary of segment pre-tax income results for the first nine 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 nine months ended September 30, 2004, income before income taxes for the Consumer segment increased $20.0 million, or 25.4%, mainly due to higher net interest income (including allocated credit for funds provided) and lower assigned loan loss costs, coupled with a 10.7% increase in non-interest income. The increase in net interest income resulted from growth in credit card, home equity and consumer lending products, coupled with stable interest expense. The increase in non-interest income resulted mainly from higher overdraft fees. Also, non-interest expense grew 1.9% over the previous year mainly due to higher corporate overhead expense allocations, occupancy and marketing expense, partly offset by lower processing and loan servicing allocations.
For the nine months ended September 30, 2004, income before taxes for the Commercial segment declined 3.4% mainly due to higher non-interest expense, but was offset by growth in net interest income and non-interest income. Net interest income for the first nine months of 2004 grew $3.2 million mainly due to lower assigned interest costs. Non-interest income also grew $5.9 million, or 11.2%, as a result of growth in fees on merchant and corporate credit card transactions. Non-interest expense increased 14.6% largely due to higher assigned costs for check processing and other internally allocated overhead costs.
Money Management segment pre-tax profitability for the nine months ended September 30, 2004 was up 10.0% over the previous year mainly due to higher non-interest income, up 1.4%, coupled with lower non-interest expense, which was down 2.8%. The reduction in expense was mainly due to lower salaries and benefits expense, which resulted largely from a staffing reduction in the trust administration area as part of a department restructuring. Higher trust revenue, partly offset by lower bond trading revenue, resulted in higher overall fee 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 invest-
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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 December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, “Accounting for Certain Loans and Debt Securities Acquired in a Transfer.” SOP 03-3 addresses the accounting for acquired loans that show evidence of having deteriorated in terms of credit quality since their origination (i.e. impaired loans). SOP 03-3 requires acquired loans to be recorded at their fair value defined as the present value of future cash flows. SOP 03-3 prohibits the carryover of an allowance for loan loss on certain acquired loans as credit losses are considered in the future cash flows assessment. SOP 03-3 is effective for loans that are acquired in fiscal years beginning after December 15, 2004. The Company will evaluate the applicability of this SOP for all prospective loans acquired in fiscal years beginning after December 15, 2004. The Company does not anticipate this Statement will have a material effect on its consolidated financial statements.
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
Three Months Ended September 30, 2004 and 2003
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Nine Months Ended September 30, 2004 and 2003
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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 continues to reflect somewhat greater exposure of the Company’s net interest income to rising rates during the first nine months of 2004. As currently projected, a two hundred basis points rising rate scenario would cause net interest income to decline $8.9 million, or 1.85%, and is slightly less than the amount reported at June 30, 2004. Under a scenario whereby rates increase one hundred basis points, it is projected net interest income would decline by $4.8 million, or 1.00%, as compared with a projected decline of $5.1 million in the previous quarter. Under current projections, the Company’s exposure to declining rates was such that a one hundred basis points decline in rates would cause net interest income to increase by $900 thousand.
During the quarter, average loans decreased $32.4 million from the previous quarter mainly as a result of a decline in business, construction and business real estate loans during the quarter, offset by some growth in consumer lending. The Company’s average available for sale investment securities portfolio, excluding fair value adjustments, also decreased by $254.7 million during the third quarter of 2004 mainly due to actions occurring late in the second quarter of 2004, including sales and maturities of securities. Also, average interest bearing deposit balances declined by $18.9 million during the third quarter due to lower certificate of deposit balances, but were partly offset by higher average balances in premium money market and interest checking accounts. Total borrowings also declined on average by $311.6 million mainly as a result of lower investment securities averages, which had been funded by overnight borrowings. During the third quarter of 2004, the Federal Reserve increased its target federal funds rate by 50 basis points, which was in addition to the 25 basis point increase occurring in June 2004.
As a result of these changes to the Company’s balance sheet and the effects of changes to the interest rate environment, the Company’s interest simulation results changed only slightly from the previous quarter. While the reduction in average borrowings in the third quarter of 2004 positively reduced interest expense as calculated in the rising rate simulations, the Company’s net interest income is still negatively impacted as a result of rate increases projected on non-maturity deposits and short-term borrowings. Also, while much of the Company’s loan portfolio does re-price higher under this scenario due to significant portions of variable rate loans, the higher balance of investment securities causes interest income to grow more slowly and not enough to offset the quicker re-pricing of liabilities. However, a change in the mix of the balance sheet, in which maturities and re-payments of investment securities are reinvested into lending products, could improve the overall profitable 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 September 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 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.
At its October 22, 2004 meeting, the Board of Directors approved the additional purchase of 4,296,580 shares, which brought the total current authorization up to 5,000,000 shares.
See Index to Exhibits
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: November 5, 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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