UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2003
OR
For the transition period from to
COMMISSION FILE NUMBER 000-49733
First Interstate BancSystem, Inc.(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: 406/255-5390
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 Exchange Act). Yes No X
The Registrant had 7,852,360 shares of common stock outstanding on June 30, 2003.
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TABLE OF CONTENTS
FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIES
Quarterly Report on Form 10-Q
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESConsolidated Balance Sheets(Dollars in thousands, except share and per share data)(Unaudited)
See accompanying notes to unaudited consolidated financial statements.
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESConsolidated Statements of Income(Dollars in thousands, except per share data)(Unaudited)
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESConsolidated Statements of Stockholders’ Equity and Comprehensive Income(Dollars in thousands, except share and per share data)(Unaudited)
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESConsolidated Statements of Cash Flows(Dollars in thousands)(Unaudited)
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESConsolidated Statements of Cash Flows (Continued)(Dollars in thousands)(Unaudited)
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Notes to Unaudited Consolidated Financial Statements(Dollars in thousands, except share and per share data)
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIESNotes to Unaudited Consolidated Financial Statements(Dollars in thousands, except share and per share data)
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Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion focuses on significant factors affecting the financial condition and results of operations of the Company during the three and six month periods ended June 30, 2003, with comparisons to 2002 as applicable.
FORWARD LOOKING STATEMENTS
Certain statements contained in this document including, without limitation, statements containing the words “believes,” “anticipates,” “expects,” and words of similar import, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, general economic and business conditions in those areas in which the Company operates; demographic changes; competition; fluctuations in interest rates; changes in business strategy or development plans; changes in governmental regulation; credit quality; and, the availability of capital to fund the expected expansion of the Company’s business. Given these uncertainties, shareholders, trust preferred security holders and prospective investors are cautioned not to place undue reliance on such forward-looking statements. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.
OVERVIEW
The Company reported net income of $10.2 million, or $1.30 per diluted share, for the three months ended June 30, 2003, as compared to $8.7 million, or $1.11 per diluted share, for the same period in 2002. Net income for the six months ended June 30, 2003 of $19.1 million, or $2.42 per diluted share, increased $1.5 million, or 8.7%, from $17.5 million, or $2.24 per diluted share, for the same period in 2002.
RESULTS OF OPERATIONS
Net Interest Income. Net interest income, the Company’s largest source of operating income, is derived from interest and fees received on interest earning assets, less interest expense incurred on interest bearing liabilities. The most significant impact on the Company’s net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest earning assets and interest bearing liabilities (“spread”). The volume of loans, investment securities and other interest earning assets, compared to the volume of interest bearing deposits and indebtedness, combined with the spread, produces changes in the net interest income between periods. On a fully-taxable equivalent (“FTE”) basis, net interest income increased $1.0 million, or 2.9%, to $36.4 million for the three months ended June 30, 2003, as compared to $35.4 million for the same period in 2002. For the six months ended June 30, 2003, FTE net interest income of $69.9 million increased $282 thousand, or less than 1%, as compared to $69.6 million for the same period in 2002. Quarter-to-date and year-to-date increases in net interest margin are primarily the result of loan and deposit growth. Redeployment of funds generated through the prepayment of mortgage-backed investment securities at lower interest rates resulted in a decline in net interest margin ratio. The FTE net interest margin ratio decreased 39 basis points to 4.43% for the six months ended June 30, 2003, as compared to 4.82% for the same period in the prior year.
Non-interest Income. The Company’s principal sources of non-interest income include service charges on deposit accounts; technology services revenues; other service charges, commissions and fees; and, income from fiduciary activities, comprised principally of fees earned on trust assets. Non-interest income increased $4.5 million, or 32.3%, to $18.4 million for the three months ended June 30, 2003 as compared to $13.9 million for the same period in 2002 and $9.1 million, or 33.7%, to $36.2 million for the six months ended June 30, 2003 as compared to $27.1 million for the same period in 2002. Significant components of the quarter-to-date and year-to-date increases are discussed below.
Other service charges, commissions and fees primarily include origination and processing fees on residential real estate loans held for sale; mortgage servicing fee income; gains on loans sold; credit card fee income; brokerage revenues; debit card interchange fee income; and, ATM service charge revenues. Other service charges, commissions and fees increased $3.7 million, or 78.6%, to $8.5 million for the three months ended June 30, 2003 as compared to $4.8 million for the same period in 2002 and $6.3 million, or 65.6%, to $15.8 million for the six months ended June 30, 2003 as compared to $9.6 million for the same period in 2002. Fueled by historically low residential lending rates, increases in revenues from
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the origination and sale of residential real estate loans account for approximately 70% of the quarter-to-date and year-to-date increases over prior year. The remaining quarter-to-date and year-to-date increases are primarily attributable to fee income resulting from higher volumes of credit and debit card transactions and increases in mortgage servicing fees and brokerage revenues.
Net investment securities gains increased $1.3 million to $1.5 million for the six months ended June 30, 2003 as compared to $189 thousand for the same period in 2002. Net gains on investment securities, primarily recorded during first quarter 2003, partially offset impairment charges on capitalized mortgage servicing rights recorded during the same periods.
Other income primarily includes increases in the cash surrender value of bank-owned life insurance, check printing income, agency stock dividends and gains on sales of fixed assets. Other income increased $540 thousand, or 52.6%, to $1.6 million for the three months ended June 30, 2003 as compared to $1.0 million for the same period in 2002 and $775 thousand, or 40.2%, to $2.7 million for the six months ended June 30, 2003 as compared to $1.9 million for the same period in 2002 primarily due to increases in the cash surrender value of bank-owned life insurance.
The Company recorded net expense related to other real estate owned (“OREO”) of $38 thousand and $54 thousand, respectively, during the three and six month periods ended June 30, 2003 as compared to net OREO income of $216 thousand and $205 thousand, respectively, during the same periods in 2002. Variations in net OREO income or expense during the periods is primarily the result of realized gains or losses on sales of OREO. OREO income or expense is directly related to prevailing economic conditions and could fluctuate significantly as economic changes occur in the Company’s market areas.
Non-interest Expense. Non-interest expense increased $2.5 million, or 7.5%, to $35.5 million for the three months ended June 30, 2003 as compared to $33.0 million for the same period in 2002 and $6.9 million, or 11.0%, to $70.1 million for the six months ended June 30, 2003 as compared to $63.1 million for the same period in 2002. Significant components of the quarter-to-date and year-to-date increases are discussed below:
Other expenses include advertising and public relation costs; legal, audit and other professional fees; office supply, postage, freight, telephone and travel expenses; other losses; amortization of mortgage servicing rights; and, impairment charges related to mortgage servicing rights and long-lived assets pending disposition. Other expense increased $2.8 million, or 30.1%, to $12.1 million for the three months ended June 30, 2003 as compared to $9.3 million for the same period in 2002 and $6.9 million, or 42.8%, to $23.2 million for the six months ended June 30, 2003 as compared to $16.2 million for the same period in 2002. Net impairment charges related to mortgage servicing rights of $2.7 million were recorded primarily during the first quarter of 2003 as compared to net impairment reversals of $157 thousand in 2002. In addition, amortization of mortgage servicing rights of $1.0 million for the three months ended June 30, 2003 and $2.2 million for the six months ended June 30, 2003 increased $765 thousand and $1.1 million, respectively, as compared to the same periods in 2002. The remaining quarter-to-date and year-to-date increases are primarily due to higher advertising expense.
Income Tax Expense. The Company’s effective combined federal and state income tax rate was 35.6% and 36.2% for the six months ended June 30, 2003 and 2002, respectively. The lower effective income tax rate in the current year is primarily due to an increase in tax exempt interest income as a percentage of income before taxes and additional tax exempt earnings on bank-owned life insurance.
Business Line Results
The following paragraphs contain a discussion of the financial performance of each of the Company’s reportable segments for the three and six month periods ended June 30, 2003 and 2002.
Community Banking. Community banking net income increased $2.0 million, or 20.0%, to $12.2 million for the three months ended June 30, 2003 as compared to $10.2 million for the same period in 2002 and $1.4 million, or 6.8%, to $21.6 million for the six months ended June 30, 2003 as compared to $20.2 million for the same period in 2002. Significant components of the quarter-to-date and year-to-date increases are discussed below.
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Net interest income increased $723 thousand, or 2.0%, to $36.7 million for the three months ended June 30, 2003, as compared to $36.0 million for the same period in 2002 primarily due to high loan volumes. For the six months ended June 30, 2003, net interest income of $70.8 million decreased $45 thousand, or less than 1%, as compared to $70.9 million for the same period in 2002 primarily due to continued low interest rates and the redeployment of funds generated through prepayment of mortgage-backed securities at lower interest rates.
Non-interest income increased $4.4 million, or 39.4%, to $15.6 million for the three months ended June 30, 2003 as compared to $11.2 million for the same period in 2002 and $8.9 million, or 41.4%, to $30.5 million for the six months ended June 30, 2003 as compared to $21.6 million for the same period in 2002. Quarter-to-date and year-to-date increases over prior periods are primarily due to increases in origination and processing fees on residential real estate loans held for sale; increases in the cash surrender value of bank-owned life insurance; increases in fee income resulting primarily from higher volumes of credit and debit card transactions; and, increases in mortgage servicing fees and brokerage revenues.
Non-interest expense increased $1.4 million, or 4.7%, to $30.8 million for the three months ended June 30, 2003 as compared to $29.4 million for the same period in 2002 and $6.6 million, or 11.8%, to $63.0 million for the six months ended June 30, 2003 as compared to $56.4 million for the same period in 2002. Quarter-to-date and year-to-date increases are primarily due to impairment charges related to mortgage servicing rights; the acceleration of amortization of mortgage servicing rights due to rapid repayments; and, increases in internal data and management fee expenses.
Technology Services. Technology services net income increased $455 thousand, or 64.0%, to $1.2 million for the three months ended June 30, 2003, as compared to $711 thousand for the same period in 2002 and $823 thousand, or 52.7%, to $2.4 million for the six months ended June 30, 2003, as compared to $1.6 million for the same period in 2002 primarily due to increases in internal data revenues and reductions in telephone expense.
Other. Other net losses increased $921 thousand, or 41.6%, to $3.1 million for the three months ended June 30, 2003 as compared to $2.2 million for the same period in 2002 and $664 thousand, or 15.7%, to $4.9 million for the six months ended June 30, 2003 as compared to $4.2 million for the same period in 2002. Increased losses are primarily due to the write-off of $1.9 million of unamortized debt issuance costs associated with trust preferred securities redeemed during second quarter 2003. The write-off was partially offset by decreases in interest expense on reissued trust preferred securities and long-term debt.
FINANCIAL CONDITION
Loans. Total loans increased $228 million, or 10.2%, to $2,465 million as of June 30, 2003 from $2,237 million as of December 31, 2002. Approximately 16% of the increase is due to the acquisition of a bank holding company and its bank subsidiary in January 2003. The remaining increase is due to internal growth primarily in real estate and commercial loans.
Investment Securities. The Company’s investment portfolio is managed to attempt to obtain the highest yield while meeting the Company’s risk tolerance and liquidity needs and satisfying pledging requirements for deposits of state and political subdivisions and securities sold under repurchase agreements. Investment securities increased $12 million, or 1.5%, to $812 million as of June 30, 2003 from $800 million as of December 31, 2002. This increase was primarily funded through deposit growth.
Premises and Equipment. Premises and equipment increased $12 million, or 13.1%, to $105 million as of June 30, 2003 from $93 million as of December 31, 2002. Approximately 50% of the increase relates to new main frame hardware and software placed into service at the end of second quarter 2003. The remaining increase is primarily due to the acquisition of a bank holding company and its bank subsidiary in January 2003 and the construction or remodel of branch facilities.
Goodwill. Goodwill increased $5 million, or 13.9%, to $38 million as of June 30, 2003 from $33 million as of December 31, 2002 due to the acquisition of a bank holding company and its bank subsidiary in January 2003.
Deposits. Total deposits increased $128 million, or 4.4%, to $3,039 million as of June 30, 2003 from $2,912 million as of December 31, 2002. Approximately 33% of the increase is due to the acquisition of a bank holding company and its bank subsidiary in January 2003. The remaining increase is the result of internal growth primarily in non-interest bearing deposits.
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Long-term Debt. Long-term debt is comprised principally of fixed rate notes with the Federal Home Loan Bank of Seattle, an unsecured revolving term loan and unsecured subordinated notes. Long-term debt increased $29 million, or 121.7%, to $52 million as of June 30, 2003 from $24 million as of December 31, 2002 primarily due to advances on fixed rate, four and seven-year borrowings from the Federal Home Loan Bank during March and April 2003.
Accounts Payable and Accrued Expenses. Accounts payable and accrued expenses increased $7 million, or 43.0%, to $24 million as of June 30, 2003 from $17 million as of December 31, 2002 primarily due to expense accruals associated with new main frame computer hardware and software.
Common Stock. Common stock increased $27 million, or 886.2%, to $30 million as of June 30, 2003 from $3 million as of December 31, 2002 primarily due to a transfer of retained earnings to common stock during first quarter 2003 and the issuance of Company common stock in partial payment for the acquisition of a bank holding company and its bank subsidiary in January 2003.
ASSET QUALITY
Non-performing Loans. Non-performing loans include loans past due 90 days or more and still accruing interest, non-accrual loans and restructured loans. Non-performing loans decreased $2 million, or 6.7%, to $32 million as of June 30, 2003 as compared to $34 million as of December 31, 2002. Approximately 54% of the decrease is related to the matured loans of one commercial borrower in the process of extension at December 31, 2002. The remaining decrease is primarily due to 2003 paydowns and charge-offs of non-accrual loans outstanding at December 31, 2002.
Provision/Allowance for Loan Losses. The Company performs a quarterly assessment of the risks inherent in its loan portfolio, as well as a detailed review of each significant asset with identified weaknesses. Based on this analysis, the Company records a provision for loan losses in order to maintain the allowance for loan losses at a level considered sufficient to provide for known and inherent losses within the loan portfolio at each balance sheet date. Fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses. The provision for loan losses increased $585 thousand, or 29.5%, to $2.6 million for the three months ended June 30, 2003 as compared to $2.0 million for the same period in 2002 and $393 thousand, or 8.5%, to $5.0 million for the six months ended June 30, 2003 as compared to $4.6 million for the same period in 2002. As of June 30, 2003, the allowance for loan losses was $38 million, or 1.55% of total loans, as compared to $36 million, or 1.62% of total loans, at December 31, 2002.
ASSET LIABILITY MANAGEMENT
The primary objective of the Company’s asset liability management process is to optimize net interest income while prudently managing balance sheet risks by understanding the levels of risk accompanying its decisions and monitoring and managing these risks. The ability to optimize net interest margin is largely dependent on the achievement of an interest rate spread that can be managed during periods of fluctuating interest rates. Interest sensitivity is a measure of the extent to which net interest income will be affected by market interest rates over a period of time. Interest rate sensitivity is related to the difference between amounts of interest earning assets and interest bearing liabilities that reprice or mature within a given period of time. Management monitors the sensitivity of the net interest margin by utilizing income simulation models and traditional interest rate gap analysis. The Company’s balance sheet structure is primarily short-term in nature with most assets and liabilities repricing or maturing in less than five years. The Company attempts to maintain a mix of interest earning assets and interest bearing liabilities such that no more than 5% of the net interest margin will be at risk over a one-year period should interest rates vary one percent. However, there can be no assurance as to the actual effect changes in interest rates will have on the Company’s net interest margin.
LIQUIDITY
Liquidity. The objective of liquidity management is to maintain the Company’s ability to meet the day-to-day cash flow requirements of customers who wish to withdraw funds or require funds to meet their credit needs. The Company manages its liquidity position to meet the needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of stockholders. The Company monitors sources and uses of funds on a daily basis to maintain an acceptable liquidity position, principally through deposit receipts and check payments; loan originations, extensions, and repayments; and, management of investment securities.
The Company’s current liquidity position is also supported by management of its investment portfolio, which provides a flow of reinvestable cash. In addition, redeployment of maturing balances in the Company’s loan portfolio also provides an important source of immediate to long-term liquidity. Additional sources of liquidity include Federal funds lines, borrowings and access to capital markets. The Company does not presently rely on off-balance sheet arrangements to provide financing, liquidity or market or credit risk support nor does it engage in derivatives and related hedging activities.
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Net cash provided by operating activities, primarily net income, totaled $36 million for the six months ended June 30, 2003 as compared to $40 million for the same period in 2002. Investing activities principally include investment security transactions and net extensions of credit to customers. Net cash used in investing activities totaled $219 million for the six months ended June 30, 2003 as compared to $77 million for the same period in the prior year. The increase in cash used in investing activities is primarily due to significant growth in extensions of credit to customers. Net cash provided by financing activities is primarily generated through changes in customer deposits, borrowings or the issuance of securities or stock. Net cash provided by financing activities totaled $109 million for the six months ended June 30, 2003 as compared to $6 million for the same period in the prior year. The increase in cash provided by financing activities is primarily due to advances on long-term debt, increases in other borrowings and deposit growth.
As a holding company, the Parent Company is a corporation separate and apart from its subsidiaries, and therefore, provides for its own liquidity. Substantially all of the Parent Company’s revenues are obtained from management fees and dividends declared and paid by it’s banking subsidiary. There are statutory and regulatory provisions that could limit the ability of the banking subsidiary to pay dividends to the Parent Company. In general, the banking subsidiary is limited, without the prior consent of its state and federal banking regulators, to paying dividends that do not exceed the current year net profits together with retained earnings from the two preceding calendar years.
CAPITAL RESOURCES
Capital Resources. The Company maintains adequate capitalization to assure depositor, investor and regulatory confidence. Management’s intent is to provide sufficient capital funds to support growth and to absorb fluctuations in income so that operations can continue in periods of uncertainty while at the same time ensuring investable funds are available to foster expansion. At June 30, 2003 the Company and its bank subsidiary each exceeded the “well-capitalized” requirements issued by the Federal Reserve Board.
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK
As of June 30, 2003, there have been no material changes in the quantitative and qualitative information about market risk provided pursuant to Item 305 of Regulation S-K as presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
Item 4.
DISCLOSURE CONTROLS AND PROCEDURES
Management of the Company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934. As of June 30, 2003, an evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, management concluded that the Company’s disclosure controls and procedures were effective in ensuring that information required to be disclosed in this Quarterly Report on Form 10-Q was recorded, processed, summarized, and reported within the time period required by the SEC’s rules and forms.
Management’s responsibilities related to establishing and maintaining effective disclosure controls and procedures include maintaining effective internal controls over financial reporting that are designed to produce reliable financial statements in accordance with accounting principles generally accepted in the United States. Management assessed the Company’s system of internal controls over financial reporting as of June 30, 2003, in relation to criteria for effective internal controls over financial reporting. Based on this assessment, management believes that, as of June 30, 2003, its system of internal controls over financial reporting met those criteria.
There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to June 30, 2003.
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PART II.
OTHER INFORMATION
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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.
FIRST INTERSTATE BANCSYSTEM, INC.
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