Commerce Bancshares - 10-Q quarterly report FY

Washington, D.C. 20549

For the transition period from                   to                                     

Commission File No. 0-2989

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

As of November 1, 2005, the registrant had outstanding 65,186,462 shares of its $5 par value common stock, registrant’s only class of common stock.

September 30, 2005 (Unaudited)

      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 2004 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, 2005 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 2004 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 September 30, 2005 and December 31, 2004.

      U.S. government and federal agency obligations included government-sponsored agencies of $780,479,000 at September 30, 2005 and $1,344,298,000 at December 31, 2004.

      Equity securities included short-term investments in money market mutual funds of $90,126,000 at September 30, 2005 and $187,705,000 at December 31, 2004. Equity securities also included $62,012,000 in FNMA and other corporate preferred stock at September 30, 2005.

      Non-marketable securities primarily included securities held for debt and regulatory purposes, which amounted to $49,927,000 and $50,703,000 at September 30, 2005 and December 31, 2004, respectively, in addition to venture capital and private equity investments, which amounted to $29,199,000 and $22,278,000 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 $4,000 and $431,000, respectively, for the three month periods ended September 30, 2005 and 2004, and $452,000 and $1,300,000 for the nine month periods ended September 30, 2005 and 2004. Estimated annual amortization expense for the years 2005 through 2009 is as follows.

      The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.

      At September 30, 2005, a liability in the amount of $5,487,000, 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 $340,367,000 at September 30, 2005.

      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 $14,627,000 at September 30, 2005. At September 30, 2005, 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 (income) is as follows:

      As discussed in the Company’s 2004 Annual Report on Form 10-K, effective January 1, 2005, substantially all benefits accrued under the Company’s pension plans were frozen. During the first nine months of 2005, the Company made no funding contributions to its defined benefit pension plan, and made minimal funding contributions to its supplemental executive retirement plan, which carries no segregated assets. The Company has no plans to make any further contributions, other than those related to the supplemental executive retirement plan, during the remainder of 2005.

      During the third quarter of 2005, the Company, after consultation with actuarial experts, reduced its estimate of the annual service cost of its defined benefit pension plan due to revisions in demographic factors. The adjustment resulted in income recognition during the current quarter, as shown above.

      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, bank card, 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, in addition to advisory and discretionary investment management services.

      The following tables present 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.

      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, 2005, the Company had interest rate swaps with a total notional amount of $121,603,000, of which two swaps with a notional amount of $15,598,000 were designated as fair value hedges of certain fixed rate loans. The remaining swaps consist of paired customer/dealer swaps with offsetting pay/receive terms. Through its International Department, the Company enters into foreign exchange contracts consisting mainly of contracts to purchase or deliver foreign currencies for customers at specific future dates. Also, mortgage loan commitments and forward sales contracts result 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 derivative instruments are listed below.

      For the third quarter of 2005, income tax expense amounted to $18,615,000 compared to $12,987,000 in the third quarter of 2004. The overall effective income tax rate for the third quarter of 2005 was 22.9% compared with 17.2% in the third quarter of 2004. For the nine months ended September 30, 2005 and 2004, income tax expense amounted to $74,131,000 and $71,150,000 and represented effective income tax rates of 30.7% and 29.8%, respectively. During the third quarter of 2005, the Company recognized income tax benefits totaling $10,279,000 associated with certain corporate tax reorganization initiatives. The Company will recognize an additional $3,426,000 tax benefit related to these initiatives in the fourth quarter of 2005. It is not expected that material tax benefits of this nature will continue beyond 2005.

      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 2004 Annual Report on Form 10-K. Results of operations for the three and nine month periods ended September 30, 2005 are not necessarily indicative of results to be attained for any other period.

      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.

      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 current period or 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 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, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogeneous manner, making loss estimates more predictable. 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 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. Further discussion of income taxes, including estimates of future income tax expense, is presented in the Income Taxes section of this discussion.

      For the quarter ended September 30, 2005, net income amounted to $62.8 million, an increase of $272 thousand, or ..4%, over the third quarter of the previous year. Return on average assets was 1.78% and the return on average equity totaled 18.12%. For the quarter, the efficiency ratio amounted to 57.61%. Net income for the third quarter of 2005 included the recognition of tax benefits of $10.3 million compared to tax benefits of $14.0 million recognized in the third quarter of 2004. During the current quarter, pre-tax income increased 7.8% over the same period last year and resulted from an improving net interest margin, 10.1% growth in non-interest income, and control of non-interest expenses. The growth in non-interest income this quarter compared with third quarter last year was due to solid growth in deposit, bank card and trust fee income. Compared to the third quarter of last year, non-interest expense grew only 1.6%. Diluted earnings per share was $.94, an increase of 6.8% over $.88 per share in the third quarter of 2004.

      Net income for the first nine months of 2005 was $167.0 million, a $676 thousand, or .4%, decrease from the first nine months of 2004. The decline in net income was due to a 2.5% increase in non-interest expense and a higher effective tax rate. These effects were partly offset by a decline of $6.3 million in the

provision for loan losses, an increase of $1.4 million in non-interest income, and growth of $1.6 million in net interest income. Diluted earnings per share increased 5.1% to $2.47, compared to $2.35 for the first nine months of last year.

      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 2005 totaled $125.8 million, a $2.1 million, or 1.7%, increase over the third quarter of 2004. The increase in net interest income was mainly the result of higher interest rates earned on loans and growth in average loan balances, which had a combined effect of increasing net income by $28.5 million. Partly offsetting the increase to net interest income were the effects of higher rates on deposits and short-term borrowing costs, and a reduction in the average balances of investment securities, which had a total combined effect of reducing net interest income by $27.4 million. As a result, the net interest rate margin was 3.86% for the third quarter of 2005, compared to 3.82% in the third quarter of 2004. For the first nine months of 2005, net interest income totaled $374.7 million, an increase of $1.6 million, or .4%, compared with the first nine months of the previous year. The net interest rate margin increased 4 basis points to 3.86% during the first nine months of 2005 compared to the prior year.

      Total interest income increased $27.0 million, or 17.8%, over the third quarter of 2004. The increase was the result of growth in average total loan balances and higher rates earned on all lending products. Average rates earned on loans increased 97 basis points, while loan volumes were up especially in the

business, construction, consumer, and credit card categories. Average rates earned on total investment securities increased 25 basis points over the third quarter of 2004, with the largest impact occurring in mortgage and asset-backed securities. Offsetting this increase to interest income was a $717.6 million decrease in the average balances of U.S. government and federal agency securities, which included sales of $359.1 million of inflation-indexed treasury securities during 2005. Inflation-related earnings decreased $2.6 million in the third quarter of 2005 from the third quarter of 2004. The average tax equivalent yield on interest earning assets was 5.46% in the third quarter of 2005 compared to 4.67% in the third quarter of 2004.

      Compared to the first nine months of 2004, total interest income increased $59.4 million. The increase reflects similar trends as noted in the quarterly comparison above, with higher average overall rates earned on interest earning assets, which occurred because of the current rising interest rate environment. In addition, growth in loan balances increased interest income. These increases were offset by lower interest income on investment securities due to declining average balances. Average tax equivalent yields on total interest earning assets for the nine months were 5.27% in 2005 and 4.63% in 2004.

      Total interest expense increased $24.8 million, or 89.0%, compared to the third quarter of 2004. This increase was mainly the result of higher rates paid on all types of deposit accounts, which rose 52 basis points to an overall rate of 1.42% in the third quarter of 2005. Deposit accounts most significantly affected by the increase included money market accounts and short-term certificates of deposit. Rates paid on overnight borrowings also increased, causing interest expense on federal funds purchased and securities sold under agreements to repurchase to increase $8.7 million. The average rate paid on total interest bearing liabilities increased to 1.76% in the third quarter of 2005 compared to 1.00% in the third quarter of 2004.

      For the first nine months of 2005, total interest expense increased $57.8 million, or 72.6%, compared with the previous year. Most of the increase resulted from a 40 basis point increase in average rates paid on deposit balances. Also contributing to the increase were higher rates paid on overnight borrowings and higher average balances in deposits, which increased $825.1 million. Partly offsetting these effects was a $219.1 million decline in average overnight borrowings. The overall average cost of total interest bearing liabilities was 1.55% for the first nine months of 2005 compared to .94% for the same period in 2004.

      Summaries of average assets and liabilities and the corresponding average rates earned/paid appear at the end of this discussion.

      For the third quarter of 2005, total non-interest income amounted to $86.9 million compared with $78.9 million in the same quarter last year, or an increase of 10.1%. The increase resulted from growth in deposit, bank card and trust fee income. Compared with the third quarter of 2004, deposit account fees increased $4.0 million, or 14.9%, mainly due to growth in deposit account overdraft fees, which grew $6.3 million over the same period last year. This strong growth was the result of increasing transaction volumes during the year and pricing changes initiated in the third quarter of 2005. Corporate cash management fee income was down slightly from the same period last year and continued to be affected by an increasing interest rate environment. Bank card fees for the current quarter increased $2.3 million, or 11.7%, over the same period last year, due mainly to higher fees earned on debit card and credit card transactions, which grew by 16.1% and 13.3%, respectively. Trust fees for the quarter increased $1.3 million, or 8.1%, over the same period last year as the result of higher fees on personal trust accounts. Included in loan fees and sales this quarter were $1.1 million in gains on sales of student loans compared with such gains of $1.6 million in the same quarter last year. Other non-interest income increased $1.0 million in the third quarter of 2005 compared to the same period last year partly due to gains on sales of banking premises, partly offset by lower activity in the state tax credit trading program.

      Non-interest income for the nine months ended September 30, 2005 increased $3.4 million, or 1.4%, over the first nine months of 2004. Deposit account fees rose $3.4 million, or 4.2%, due to growth of 21.0% in fee income on overdraft and return items. This growth was partly offset by lower cash management revenue. Compared to the previous year, bank card fee income rose $6.2 million, or 10.9%, with debit and credit card fees growing 16.4% and 13.0%, respectively. Trust fees increased $2.4 million, or 5.1%, over the previous year as a result of both proprietary mutual fund administration fees and growth in personal trust accounts. Bond trading income declined $2.2 million due to lower sales activity. Loan fees and sales decreased by $1.2 million as gains on student loan sales declined from $7.9 million in the first nine months of 2004 to $7.0 million in 2005. Other non-interest income included increases in ATM fees and check float income, partly offset by lower operating lease revenues and tax credit sales income.

      During the current quarter, net securities gains amounted to $289 thousand compared with net securities losses of $148 thousand in the same period last year. The net securities gains in the third quarter of 2005 included an impairment charge of $800 thousand on a private equity investment held by a venture capital subsidiary. On a year-to-date basis, securities transactions resulted in net gains of $5.3 million and $11.6 million for 2005 and 2004, respectively. During the first nine months of 2005, the Company undertook initiatives to review and re-position its investment securities portfolio to address such things as concentration, duration and interest rate risk. Consequently, during the first nine months of 2005, the Company sold available for sale securities totaling $1.6 billion. These sales were comprised mainly of $533.9 million in U.S. government agency securities, $592.9 million in asset-backed securities, and $359.1 million in inflation-indexed treasury securities. Also as a result of the repositioning, the Company purchased $2.0 billion of available for sale securities during the nine month period. The purchases were comprised mainly of $1.0 billion in mortgage-backed securities and $518.1 million in other asset-backed securities.

      Non-interest expense for the quarter amounted to $122.4 million, an increase of $1.9 million, or 1.6%, compared with $120.5 million recorded in the third quarter of last year. Compared to the third quarter of last year, salaries and benefits expense increased $1.1 million, or 1.7%, as a result of normal merit increases, partly offset by lower retirement and medical insurance costs. Costs for supplies and communication declined $695 thousand, or 7.6%, from amounts recorded in the third quarter of last year mainly due to lower costs for supplies, postage and telephone. Occupancy costs grew by $537 thousand, or 5.5%, due to higher costs for depreciation and utilities. Data processing and software costs increased $639 thousand, or 5.6%, as a result of higher costs for bank card and online banking processing fees, partly offset by lower costs for software license fees and amortization.

      Non-interest expense increased $9.0 million, or 2.5%, in the first nine months of 2005 over the same period in 2004. Salaries and benefits increased $5.2 million, or 2.6%, due to merit increases, partly offset by lower retirement and medical insurance costs. Full-time equivalent employees totaled 4,827 and 4,821 at September 30, 2005 and 2004, respectively. Data processing and software costs increased $1.7 million, or 5.1%, due to the reasons mentioned above. Smaller variances occurred in marketing and equipment expense, which increased $355 thousand and $60 thousand, respectively, and supplies and communication and occupancy, which declined $511 thousand and $158 thousand, respectively. Other non-interest expense increased $2.3 million, or 5.5%, over the prior period due to increases in recruiting expense, proprietary mutual funds expense subsidies, and minority interest expense relating to investment gains recorded by venture capital affiliates. These increases were partly offset by lower loan collection expense, lower intangible asset amortization, and higher capitalized loan costs.