Commerce Bancshares - 10-Q quarterly report FY

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Washington, D.C. 20549

For the transition period from                   to                                     

Commission File No. 0-2989

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(Exact name of registrant as specified in its charter)

June 30, 2006 (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 2005 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. The results of operations for the three and six month periods ended June 30, 2006 are not necessarily indicative of results to be attained 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 2005 Annual Report on Form 10-K.

      On July 21, 2006, Commerce Bank, N.A., (Missouri) (the Bank) a subsidiary of the Company, acquired the banking business of Boone National Savings and Loan Association (Boone). Boone operates four branches in Columbia, Missouri, and loan production offices in Ashland and Lake Ozark, Missouri. The Bank acquired loans and deposits of approximately $128 million and $101 million, respectively, assumed other liabilities of approximately $27 million, and paid a purchase price premium of approximately $16 million in cash. Goodwill and core deposit intangible of approximately $19 million is expected to be recorded as a result of the transaction. No other intangible assets were recognized as a result of the transaction.

      On April 13, 2006, the Company and West Pointe Bancorp, Inc. (West Pointe) signed a definitive merger agreement in which the Company will acquire West Pointe in a transaction to be valued at $80.9 million in stock and cash. The Company’s acquisition of West Pointe will add approximately $477 million in assets (including $256 million in loans), $402 million in deposits, five branch locations and 25 ATMs in St. Clair County, Illinois (southwestern Illinois region of metropolitan St. Louis).

      Under terms of the agreement, shareholders of West Pointe will be entitled to elect to receive either cash or stock, with the cash portion of the transaction not to exceed 25% of the total consideration of $80.9 million. Elections will be subject to proration procedures. It is anticipated that the transaction will be completed in the third quarter of 2006, pending regulatory approvals and certain closing conditions.

      Major classifications of loans at June 30, 2006 and December 31, 2005 are as follows.

      At June 30, 2006, loans held for sale amounted to $267,059,000, consisting of $256,724,000 in student loans and $10,335,000 in certain fixed rate residential mortgage loans, which are included in the “Real estate - personal” category in the table above. In 2006, the Company elected to classify its student loan portfolio as held for sale in accordance with its student loan sale policy. Held for sale real estate loans outstanding at December 31, 2005 amounted to $6,172,000.

      Impaired loans include loans on non-accrual status and other loans on the Company’s watch list classified as substandard and more than 60 days past due. Impaired loans were $14,586,000 at June 30, 2006 compared to $9,973,000 at December 31, 2005.

      The following is a summary of the allowance for loan losses.

      Investment securities, at fair value, consist of the following at June 30, 2006 and December 31, 2005.

      Available for sale equity securities included short-term investments in money market mutual funds of $113,090,000 at June 30, 2006 and $111,736,000 at December 31, 2005. Equity securities also included FNMA and other corporate preferred stock of $29,850,000 at June 30, 2006 and $36,850,000 at December 31, 2005.

      Non-marketable securities included securities held for debt and regulatory purposes, which amounted to $39,986,000 and $45,417,000 at June 30, 2006 and December 31, 2005, respectively, in addition to venture capital and private equity investments, which amounted to $41,327,000 and $31,836,000 at the respective dates. During the first six months of 2006, net gains of $5,003,000 were recognized on venture capital and private equity investments, which consisted of both realized gains and fair value adjustments.

      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 $3,000 and $67,000, respectively, for the three month periods ended June 30, 2006 and 2005, and $4,000 and $448,000 for the six month periods ended June 30, 2006 and 2005.

      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.

      Upon issuance of standby letters of credit, the Company recognizes a liability for the fair value of the obligation undertaken, which is estimated to be equivalent to the amount of fees to be received from the customer over the life of the agreement. At June 30, 2006 that net liability was $6,893,000, which will be amortized into income over the remaining life of the respective commitments. The contract amount of these letters of credit, which represents the maximum potential future payments guaranteed by the Company, was $437,304,000 at June 30, 2006.

      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 $14,301,000 at June 30, 2006. At June 30, 2006, the Company had a recorded liability of $4,145,000 in principal and accrued interest to date, representing amounts owed to the security holders.

      The amount of net pension cost (income) is as follows:

      Substantially all benefits under the Company’s defined benefit pension plan were frozen effective January 1, 2005. During the first six months of 2006, the Company made no funding contributions to its defined benefit pension plan, and made minimal funding contributions to a supplemental executive retirement plan (the CERP), which carries no segregated assets. The Company has no plans to make any further contributions, other than those related to the CERP, during the remainder of 2006. The income recognized for the defined benefit pension plan for the first six months of 2006 was primarily due to the greater than expected return on plan assets for the year ended September 30, 2005 (the valuation date).

      Presented below is a summary of the components used to calculate basic and diluted earnings per share.

      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.

      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. Management periodically makes changes to methods of assigning costs and income to its business segments to better reflect operating results. If appropriate, these changes are reflected in prior year information presented below.

      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’s interest rate risk management strategy includes the ability to modify the re-pricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash flows. Interest rate swaps are used on a limited basis as part of this strategy. At June 30, 2006, the Company had entered into two interest rate swaps with a notional amount of $14,849,000, which are designated as fair value hedges of certain fixed rate loans. The Company also sells swap contracts to customers who wish to modify their interest rate sensitivity. These swaps are offset by matching contracts purchased by the Company from other financial institutions. Because of the matching terms of the offsetting contracts, the effect of these transactions on net income is minimal. The notional amount of these types of swaps at June 30, 2006 was $170,858,000. These swaps are accounted for as free-standing derivatives and changes in their fair value were recorded in other non-interest income.

      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 second quarter of 2006, income tax expense amounted to $27,387,000 compared to $29,484,000 in the second quarter of 2005. The effective income tax rate for the Company was 33.1% in the current quarter compared to 35.2% in the same quarter last year. For the six months ended June 30, 2006 and 2005, income tax expense amounted to $53,233,000 and $55,516,000, resulting in effective income tax rates of 33.0% and 34.8%, respectively.

      During 2005 and previous years, stock-based awards were issued to key employees under several stock option and award plans, all of which had been approved by shareholders. During this period, awards were comprised of stock options and nonvested stock. At December 31, 2005, these plans were replaced by the Company’s 2005 Equity Incentive Plan which was approved by shareholders on April 20, 2005. The new plan allows for issuance of various types of awards, including stock options, stock appreciation rights, restricted stock and restricted stock units, performance awards and stock-based awards. During the first six months of 2006, stock-based compensation was issued in the form of stock appreciation rights (SARs) and non-vested stock, and at June 30, 2006, 3,721,178 shares remained available for issuance under the new plan. The stock-based compensation expense that has been charged against income was $1,280,000 and $1,305,000 for the three month periods ended June 30, 2006 and 2005, respectively, and $2,079,000 and $4,078,000, respectively, for the six month periods ended June 30, 2006 and 2005. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $480,000 and $489,000 for the three month periods ended June 30, 2006 and 2005, respectively, and $780,000 and $1,530,000, respectively for the six month periods ended June 30, 2006 and 2005. The decline in stock-based compensation in 2006 compared to 2005 occurred because of a change in the vesting period of certain awards granted in the first quarter of 2006, in addition to the effects of the forfeiture accounting requirements of Statement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment”, both of which are discussed below.

      In determining compensation cost, the Black-Scholes option-pricing model is used to estimate the fair value of options and SARs on date of grant. The Black-Scholes model is a closed-end model that uses the assumptions in the following table. Expected volatility is based on historical volatility of the Company’s stock and a consideration of other factors. The Company uses historical exercise behavior and other factors to estimate the expected term of the options and SARs, which represents the period of time that the options

and SARs granted are expected to be outstanding. The risk-free rate for the expected term is based on the U.S. Treasury zero coupon spot rates in effect at the time of grant.

      Below are the fair values of SARs and stock options granted, using the Black-Scholes option-pricing model, including the model assumptions for those grants. SARs and stock options were granted with an exercise price equal to the market price of the Company’s stock at the date of grant and have10-year contractual terms. SARs, which were granted for the first time in 2006, vest on a graded basis over 4 years of continuous service. All SARs must be settled in stock under provisions of the plan. Stock options, which were granted in 2005 and previous years, vest on a graded basis over 3 years of continuous service.

      A summary of option activity during the first six months of 2006 is presented below.

      A summary of SAR activity during the first six months of 2006 is presented below.

      Additional information about stock options exercised is presented below. The SARs granted during the first six months of 2006 are not exercisable until 2007.

      Nonvested stock is awarded to key employees, by action of the Board of Directors. These awards generally vest after 5 years of continued employment. There are restrictions as to transferability, sale, pledging, or assigning, among others, prior to the end of the 5 year vesting period. Dividend and voting rights are conferred upon grant. A summary of the status of the Company’s nonvested share awards, as of June 30, 2006, and changes during the six month period then ended is presented below.

      As of June 30, 2006, there was $3,574,000 of total unrecognized compensation cost (net of estimated forfeitures) related to nonvested shares. That cost is expected to be recognized over a weighted-average period of 3.5 years. The total fair value (at vest date) of shares vested during the three month periods ended June 30, 2006 and 2005 was $180,000 and $61,000, respectively, and during the six month periods ended June 30, 2006 and 2005 was $1,477,000 and $1,188,000, respectively.

      The Company adopted Financial Accounting Statement No. 123R on January 1, 2006. As a result of adoption, the Company recorded a reduction of $543,000 in stock-based compensation expense in the first quarter of 2006. This adjustment resulted from a change by the Company from its former policy of recognizing the effect of forfeitures only as they occurred to the Statement’s requirement to estimate the number of outstanding instruments for which the requisite service is not expected to be rendered. The adjustment was not considered to be material to the Company’s financial statements and, accordingly, was not presented separately as the cumulative effect of a change in accounting principle in the accompanying consolidated income statement.

      The Company has a stock repurchase program under which 5,000,000 shares of common stock were authorized for repurchase by the Board of Directors in October 2005. At June 30, 2006, 2,587,833 shares remain available to be purchased under this authorization. A portion of shares repurchased during the next twelve months will be used to satisfy share option exercises, which are expected to range from 600,000 to 700,000 shares.

      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 2005 Annual Report on Form 10-K. Results of operations for the three and six month periods ended June 30, 2006 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, the valuation of certain non-marketable investments, 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 homogenous 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 Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $46.0 million at June 30, 2006. 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.

      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 is presented in the Income Taxes section of this discussion.

      For the quarter ended June 30, 2006, net income amounted to $55.3 million, an increase of $965 thousand, or 1.8%, over the second quarter of the previous year. For the current quarter, the annualized return on average assets was 1.61%, the annualized return on average equity was 16.59%, and the efficiency ratio was 60.35%. Compared to the second quarter of last year, net interest income decreased .7% while non-interest income grew 7.6%, with increases in bank card, deposit account and trust fee income. Additionally, the provision for loan losses amounted to $5.7 million for the quarter, while non-interest expense grew by 5.3%. Diluted earnings per share was $.82, an increase of 6.5% over $.77 per share in the second quarter of 2005.

      Net income for the first six months of 2006 was $108.3 million, a $4.1 million, or 3.9%, increase over the first six months of 2005. The increase in net income was primarily due to a 9.2% increase in non-interest income, an improvement in net interest income, and a lower effective tax rate. These effects were partly offset by a 5.1% increase in non-interest expense and a $2.2 million increase in the provision for loan losses. Diluted earnings per share increased 9.6% to $1.60, compared to $1.46 for the first six months of last year.

      On July 21, 2006, Commerce Bank, N.A., (Missouri) (the Bank) a subsidiary of the Company, acquired the banking business of Boone National Savings and Loan Association (Boone). Boone operates four branches in Columbia, Missouri, and loan production offices in Ashland and Lake Ozark, Missouri. The Bank acquired loans and deposits of approximately $128 million and $101 million, respectively, assumed other liabilities of approximately $27 million, and paid a purchase price premium of approximately $16 million in cash. Goodwill and core deposit intangible of approximately $19 million is expected to be recorded as a result of the transaction. No other intangible assets were recognized as a result of the transaction.

      On April 13, 2006, the Company and West Pointe Bancorp, Inc. (West Pointe) signed a definitive merger agreement in which the Company will acquire West Pointe in a transaction to be valued at $80.9 million in stock and cash. The Company’s acquisition of West Pointe will add approximately $477 million in assets (including $256 million in loans), $402 million in deposits, five branch locations and 25 ATMs in St. Clair County, Illinois (southwestern Illinois region of metropolitan St. Louis).

      Under terms of the agreement, shareholders of West Pointe will be entitled to elect to receive either cash or stock, with the cash portion of the transaction not to exceed 25% of the total consideration of $80.9 million. Elections will be subject to proration procedures. It is anticipated that the transaction will be completed in the third quarter of 2006, pending regulatory approvals and certain closing conditions.

      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.