First Interstate BancSystem - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

401 North 31st Street, Billings, MT 59116-0918

(Address of principal executive offices)                    (Zip Code)

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 þ      No o     

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

Yes o      No þ     

The Registrant had 8,114,891 shares of common stock outstanding on April 30, 2006.

FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIES

Quarterly Report on Form 10-Q

Consolidated Balance Sheets
(Dollars in thousands, except share data)
(Unaudited)

Consolidated Statements of Income
(Dollars in thousands, except per share data)
(Unaudited)

Consolidated Statements of Stockholders’ Equity and Comprehensive Income
(Dollars in thousands, except share and per share data)
(Unaudited)

Consolidated Statements of Cash Flows
(Dollars in thousands)
(Unaudited)

The following table illustrates the effect on operating results and per share information had the Company accounted for stock-based compensation in accordance with SFAS 123R for the three months ended March 31, 2005:

At March 31, 2006, the Company had $1,730 of unrecognized compensation cost related to stock options and restricted stock awards which is expected to be recognized over a weighted-average period of 1.0 year. Compensation expense associated with stock options and restricted stock awards of $154, net of related tax benefits of $96, was recognized in the Company’s consolidated income statement for the three months ended March 31, 2006 and 2005, respectively. The total weighted average fair value of stock options and restricted stock awards vested during the three months ended March 31, 2006 and 2005 was $437 and $404, respectively.

All options granted under the 2001 Stock Option Plan have an exercise price equal to fair value at the date of grant, may be subject to vesting as determined by the Company’s Board of Directors or Compensation Committee and can be exercised for periods of up to ten years from the date of grant. Stock issued upon exercise of options is subject to a shareholder agreement prohibiting transfer of the stock for a period of six months following the exercise. In addition, the shareholder agreement grants the Company a right of first refusal to repurchase the stock and provides the Company a right to call some or all of the stock under certain conditions.

The Company uses the Black-Scholes option pricing model to estimate the fair value of stock-based awards with the following weighted-average assumptions for the indicated periods.

The assumptions above are based on historical exercise and post-vesting employment termination behaviors and expected future exercising patterns of employees; and, historical volatility of the Company’s common stock calculated using the quarterly appraised value of a minority interest over the expected life of options in 2006 and the contractual option term in 2005. Risk-free interest rates are based on U.S. treasury constant maturity yields in effect as of each grant date for treasury securities with maturities approximating the expected life of options granted.

The following table represents stock option activity for the three months ended March 31, 2006:

At March 31, 2006, the Company had 407,725 shares available for future stock option grants to employees and directors under the 2001 Stock Option Plan. The aggregate intrinsic value of options outstanding and options exercisable were $19,421 and $17,450, respectively, as of March 31, 2006 and $15,057 and $13,607, respectively, as of March 31, 2005. The total intrinsic value of stock options exercised during the three months ended March 31, 2006 and 2005 was $1,729 and $405, respectively.

Net cash proceeds from the exercise of stock options were $1,675 for the three months ended March 31, 2006. The Company receives a tax deduction generally equal to the excess of the fair value of common stock received pursuant to an option exercise over the exercise price of the option. Under SFAS 123R, tax benefits from the exercise of stock options are reported as financing cash flows in the consolidated statements of cash flows rather than as operating cash flows as was required under APB 25. For the three months ended March 31, 2006, the Company recorded financing cash flows of $656 related to tax benefits from the exercise of stock options. The actual income tax benefit realized for the tax deductions from share option exercises totaled $661 for the same period.

The following table summarizes the Company’s nonvested stock option activity for the three months ended March 31, 2006:

Compensation expense related to stock options awards of $250 was included in salaries, wages and benefits expense on the Company’s consolidated income statements for the three months ended March 31, 2006. No compensation expense related to stock option awards was recorded in 2005.

Common stock issued under the 2004 Restricted Stock Plan may not be sold or otherwise transferred until restrictions have lapsed or performance objectives have been obtained. During the vesting period, participants have voting rights and receive dividends on the restricted shares. Upon termination of employment, common shares upon which restrictions have not lapsed must be returned to the Company. The unearned stock-based compensation related to these awards is amortized to compensation expense over the period the restrictions lapse (generally three years). As of March 31, 2006, unearned stock-based compensation of $267 associated with these awards was included in common stock on the Company’s consolidated financial statements. Compensation expense related to restricted stock awards of $63 and $56 was included in salaries, wages and benefits expense on the Company’s consolidated income statements for the three month periods ended March 31, 2006 and 2005, respectively.

The following table represents the shares that were granted and outstanding as of March 31, 2006 and December 31, 2005:

Selected segment information for the three month periods ended March 31, 2006 and 2005 follows:

period of estimated net servicing income or net servicing loss and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date; or, (2) measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur. At its initial adoption, SFAS No. 156 permits a one-time reclassification of available-for-sale securities to trading securities provided that the available-for-sale securities are identified in some manner as offsetting exposure to changes in fair value of servicing assets or servicing liabilities subsequently being measured at fair value. SFAS No. 156 requires separate financial statement presentation of servicing assets and servicing liabilities subsequently measured at fair value and requires additional disclosures for all separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective for the Company on January 1, 2007. The Company does not expect adoption to have a significant impact on the consolidated financial statements, results of operations or liquidity of the Company.

During February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and, amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after December 31, 2006. As of March 31, 2006, the Company did not hold any derivative instruments nor was it engaged in hedging activities subject to SFAS Nos. 155, 140 or 133. As such, the adoption of SFAS No. 155 is not expected to have a material impact on the consolidated financial statements, results of operations or liquidity of the Company.

     The following discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, including the audited financial statements contained therein, filed with the Securities and Exchange Commission.

     This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. Any statements about the Company’s plans, objectives, expectations, strategies, beliefs, or future performance or events constitute forward-looking statements. Such statements are identified as those that include words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “may” or similar expressions. Forward-looking statements involve known and unknown risks, uncertainties, assumptions, estimates and other important factors that could cause actual results to differ materially from any results, performance or events expressed or implied by such forward-looking statements. All forward-looking statements are qualified in their entirety by reference to risk factors discussed in Item 1A of the Company’s Annual Report of Form 10-K for the year ended December 31, 2005, including, among others: (i) credit risk; (ii) credit concentration and economic conditions in Montana and Wyoming; (iii) declines in real estate values; (iv) changes in interest rates; (v) inability to meet liquidity requirements; (vi) availability of capital; (vii) competition; (viii) dependence on technology; (ix) ineffective internal operational controls; (x) difficulties in execution of business strategy; (xi) disruption of vital infrastructure; (xii) changes in or noncompliance with governmental regulations; (xiii) restrictions on dividends and stock redemptions; (xiv) capital required to support the Company’s bank subsidiary (the “Bank”); and (xv) investment risks affecting holders of common stock. Because the foregoing factors could cause actual results or outcomes to differ materially from those expressed or implied in any forward-looking statements, undue reliance should not be placed on any forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of future events or developments.

     The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which the Company operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates.

     The Company’s accounting policies are fundamental to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operations. The most significant accounting policies followed by the Company are presented in Note 1 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

     The Company’s critical accounting estimates are summarized below. Management considers an accounting estimate to be critical if: (1) the accounting estimate requires management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain, and (2) changes in the estimate that are reasonably likely to occur from period to period, or the use of different estimates that management could have reasonably used in the current period, would have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.

     The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements, including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio.

The allowance for loan losses is maintained at an amount the Company believes is sufficient to provide for estimated losses inherent in its loan portfolio at each balance sheet date. Management believes the process for determining the allowance for loan losses takes into account all of the significant potential factors that could result in credit losses. However, the process includes judgmental and quantitative elements that may be subject to significant change. To the extent actual outcomes differ from the Company’s estimates, additional provision for loan losses could be required, which could adversely affect earnings or financial performance in future periods. Note 1 of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 describes the methodology used to determine the allowance for loan losses. A discussion of the factors driving changes in the amount of the allowance for loan losses is included herein under the heading “Asset Quality, Provision/Allowance for Loan Losses.”

     The Company recognizes as assets the rights to service mortgage loans for others, whether acquired or internally originated. Mortgage servicing rights are initially recorded at fair value and are amortized over the period of estimated servicing income. Mortgage servicing rights are carried on the consolidated balance sheet at the lower of amortized cost or fair value. The Company utilizes the expertise of a third-party consultant to estimate the fair value of its mortgage servicing rights quarterly. In evaluating the mortgage servicing rights, the consultant uses discounted cash flow modeling techniques, which require estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, costs to service, as well as interest rate assumptions that contemplate the risk involved. Management believes the valuation techniques and assumptions used by the consultant are reasonable.

     Determining the fair value of mortgage servicing rights is considered a critical accounting estimate because of the assets’ sensitivity to changes in estimates and assumptions used, particularly loan prepayment speeds and discount rates. Imprecision in estimating these factors can impact the amount of revenue or loss recorded in the Company’s financial statements. Notes 1 and 7 of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 describe the methodology used to determine fair value of mortgage servicing rights.

     During the first quarter of 2006, the Company remained focused on improving operating efficiency and identifying new opportunities to generate additional noninterest income. This strategy resulted in increased earnings during the first quarter of 2006. Net income increased $4.2 million, or 34.9%, to $16.1 million, or $1.95 per diluted share, for the quarter ended March 31, 2006 as compared to $12.0 million, or $1.48 per diluted share, for the same period in 2005. First quarter 2006 net interest income, on a fully taxable-equivalent basis, of $46.5 million increased $6.4 million partly due to growth in average earning assets. Average earning assets grew 11.0% and comprised a larger percentage of total assets during the three months ended March 31, 2006, as compared to the same period in 2005. In addition, noninterest-bearing deposits and common equity comprised a larger share of the funding base during first quarter 2006, as compared to the same period in 2005, allowing the Company to be less reliant on higher costing funding sources, such as time deposits, in 2006. Net income during first quarter 2006 was also positively impacted by lower expenses associated with discontinuation of operations at Wal-Mart in-store banking offices as described below; decreases in losses on sales of investment securities; increases in fee income resulting from debit card transaction volumes; and, increases in revenues from technology and financial services. Partially offsetting these improvements in net income were increases in salaries, wages and employee benefit expenses.

     On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payments,” which requires all share-based payments to be recognized in the financial statements based on the fair value of the award at the date of grant. Adoption of SFAS No. 123R resulted in the recognition of compensation expense related to stock option and restricted stock awards, net of related income tax benefits, of $113 thousand during the first quarter of 2006.

     In January 2005, the Company made a strategic decision to discontinue the operation of nine banking offices located inside Wal-Mart stores. During 2005, operations at five of the nine Wal-Mart in-store banking offices were discontinued and customer loan and deposit accounts were transferred to existing banking offices located in the same communities. During January 2006, operations were discontinued and customers’ accounts were transferred at three of the four remaining Wal-Mart in-store banking offices and the final Wal-Mart in-store banking office was sold. Expenses directly related to the discontinuation of operations totaled $23 and $533 during the three months ended March 31, 2006 and 2005, respectively.

     Net Interest Income. Net interest income, the Company’s largest source of operating income, is derived from interest, dividends 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. Noninterest-bearing sources of funds, such as demand deposits and stockholders’ equity, also support earning assets. The impact of free funding sources is captured in the net interest margin, which is calculated as net interest income divided by average earning assets. Given the interest free nature of free funding sources, the net interest margin is generally higher than the spread.

     The following table presents, for the periods indicated, condensed average balance sheet information for the Company, together with interest income and yields earned on average interest earning assets and interest expense and rates paid on average interest bearing liabilities.

     Although faced with a continuing yield-rate environment in which short-term interest rates are increasing faster than long-term interest rates, which typically constrains a bank’s ability to maintain its net interest margin, the Company’s net interest income, on a fully taxable equivalent (“FTE”) basis, increased $6.4 million, or 15.9%, to $46.5 million for the three months ended March 31, 2006 as compared to $40.1 million for the same period in 2005. The net FTE yield on interest earning assets increased 20 basis points to 4.59% for the three months ended March 31, 2006 as compared to 4.39% for the same period in 2005. Improvements in net FTE interest income and net FTE yield for the three months ended March 31, 2006, as compared to the same period in 2005, are partly attributable to growth in average earning assets and higher yields on investment securities. Average earning assets grew 11.0% and comprised a larger percentage of total assets during the three months ended March 31, 2006, as compared to the same period in 2005. A partial restructure of the Company’s investment security portfolio in 2005 contributed to the increase in yield for the three months ended March 31, 2006 as compared to the same period in 2005. In addition, free funding sources comprised a larger share of the funding base during first quarter 2006, as compared to the same period in 2005, allowing the Company to be less reliant on higher costing funding sources, such as time deposits, in 2006.

     The table below sets forth, for the periods indicated, a summary of the changes in interest income and interest expense resulting from estimated changes in average asset and liability balances (“volume”) and estimated changes in average interest rates (“rate”). Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percent changes in average volume and average rate as they compare to each other.

     Noninterest Income. The Company’s principal sources of noninterest income include other service charges, commissions and fees; service charges on deposit accounts; technology services revenues; income from the origination and sale of loans; and, revenues from financial services. Noninterest income increased $2.2 million, or 12.8%, to $19.1 million for the three months ended March 31, 2006 as compared to $16.9 million for the same period in 2005. Significant components of the increase are discussed below.

     Other service charges, commissions and fees primarily include debit and credit card interchange income, mortgage servicing fees, investment services revenues and ATM service charge revenues. Other service charges, commissions and fees increased $427 thousand, or 8.9%, to $5.2 million for the three months ended March 31, 2006 as compared to $4.8 million for the same period in 2005 primarily due to additional fee income from higher volumes of debit card transactions and increases in mortgage servicing revenues, the result of increases in the principal balance of loans serviced.

     Technology services revenues increased $325 thousand, or 9.7%, to $3.7 million for the three months ended March 31, 2006 as compared to $3.3 million for the same period in 2005 primarily due to increases in the number of customers using core data processing services and the volume of core data and debit card transactions processed.

     Financial services revenues, comprised principally of brokerage revenues and fees earned for management of trust assets, increased $169 thousand, or 7.3%, to $2.5 million for the three months ended March 31, 2006 as compared to $2.3 million for the same period in 2005, primarily due to higher asset management fees resulting from the improved market performance of underlying trust account assets and the addition of new trust customers.

     The Company recorded no gains or losses on the sale of investment securities during the three months ended March 31, 2006 as compared to net losses on sales of $692 thousand for the same period in 2005. During 2005, lower yielding U.S. government agency securities were sold and the proceeds were reinvested in higher yielding mortgage-backed and U.S. government agency securities.

     Other income primarily includes increases in the cash surrender value of and death benefits from company-owned life insurance, check printing income, agency stock dividends and gains of sales of assets other than investment securities. Other income increased $435 thousand, or 32.6%, to $1.8 million during the three months ended March 31, 2006 as compared to $1.3 million for the same period in 2005 primarily due to higher earnings on securities held in trust under deferred compensation plans, increases in earnings of unconsolidated joint ventures and higher check printing income. Additionally, the Company recorded an $85 gain on the sale of a branch banking office in February 2006.

     Noninterest Expense. Noninterest expense increased $1.8 million, or 4.9%, to $38.2 million for the three months ended March 31, 2006 as compared to $36.4 million for the same period in 2005. Significant components of the increase are discussed below.

     Salaries, wages and employee benefits expense increased $1.7 million, or 8.5%, to $21.3 million for the three months ended March 31, 2006 as compared to $19.7 million for the same period in 2005 primarily due to inflationary wage increases and higher incentive bonus accruals. Also contributing to the increase in salaries, wages and employee benefits expense in the current year was the adoption of SFAS 123R on January 1, 2006. Under the provisions of SFAS No. 123R, the Company recognized compensation expense for stock option and restricted stock awards of $250 thousand during the three months ended March 31, 2006 as compared to $56 thousand during the same period in 2005.

     Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income. Changes in estimated servicing period and growth in the serviced loan portfolio cause amortization expense to vary between periods. Mortgage servicing rights amortization decreased $228 thousand, or 19.5%, to $943 thousand for the three months ended March 31, 2006 as compared to $1.2 million for the same period in 2005.

     Mortgage servicing rights are evaluated quarterly for impairment by discounting the expected future cash flows, taking into consideration the estimated level of prepayments based on current industry expectations and the predominant risk characteristics of the underlying loans. Impairment adjustments are recorded through a valuation allowance. The valuation allowance is adjusted for changes in impairment through a charge to current period earnings. The Company reversed previously recorded impairment of $170 thousand and $463 thousand during the three month periods ended March 31, 2006 and 2005, respectively.

     Other expenses primarily include advertising and public relations costs; office supply, postage, freight, telephone and travel expenses; donations expense; board of director fees; and, other losses. Other expenses decreased $391 thousand, or 5.3%, to $7.0 million for the three months ended March 31, 2006 as compared to $7.4 million for the same period in the prior year primarily due to expenses related to the discontinuation of operations at Wal-Mart in-store banking offices recorded during first quarter 2005.

     Income Tax Expense. The Company’s effective federal income tax rate was 30.8% and 30.6% for the three months ended March 31, 2006 and 2005, respectively. State income tax applies primarily to pretax earnings generated within Montana, Colorado, Idaho and Oregon. The Company’s effective state tax rate was 4.1% and 3.9% for the three months ended March 31, 2006 and 2005, respectively.

     The Company’s primary operating segment is Community Banking. The Community Banking segment represented over 90% of the combined revenues and income of the Company during the three months ended March 31, 2006 and 2005, and the consolidated assets of the Company as of March 31, 2006 and December 31, 2005.

     The following table summarizes net income (loss) for each of the Company’s operating segments.

     Net income from the Community Banking operating segment increased $4.1 million, or 33.8%, to $16.4 million for the three months ended March 31, 2006 as compared to $12.2 million for the same period in 2005. Significant components of this increase are discussed in “Results of Operations” included herein.

     Loans. Total loans increased $83 million, or 2.7%, to $3,117 million as of March 31, 2006 from $3,034 million as of December 31, 2005. All significant loan categories demonstrated organic growth during the first quarter of 2006, except consumer loans which decreased less than 1%. The most significant growth occurred in real estate loans, which, in aggregate, constituted 62.2% of the total loan portfolio as of March 31, 2006 and 61.7% of the total loan portfolio as of December 31, 2005. Real estate loans increased $65 million, or 3.4%, to $1,939 million as of March 31, 2006 from $1,874 as of December 31, 2005, primarily due to increases in construction loans, the result of continued strong demand for housing in the Company’s market areas.