First Financial Bank - 10-Q quarterly report FY

 

     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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer þ    Accelerated filer o    Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of Exchange Act).
Yes o    No þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

See notes to consolidated financial statements.

See notes to consolidated financial statements.

See notes to consolidated financial statements.

See notes to consolidated financial statements.

The consolidated financial statements for interim periods are unaudited; however, in the opinion of the management of First Financial Bancorp. (First Financial), all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation have been included.

The consolidated financial statements of First Financial, a bank holding company, include the accounts of First Financial and its wholly-owned subsidiaries - First Financial Bank, N.A. and First Financial Capital Advisors LLC, a registered investment advisory company. All significant intercompany transactions and accounts have been eliminated in consolidation.

The accompanying financial statements have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles for annual financial statements.

The consolidated balance sheet at December 31, 2005, has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements for annual periods. For further information, refer to the consolidated financial statements and footnotes thereto included in the First Financial Bancorp. Annual Report on Form 10-K for the year ended December 31, 2005.

First Financial adopted the provisions of SFAS No. 123(R), “Share-Based Payment,” effective January 1, 2006, using the modified-prospective transition method which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation expense over the service period for awards expected to vest. This Statement applies to all awards granted after January 1, 2006 and to awards modified, repurchased, or cancelled after that date. Prior to January 1, 2006, First Financial accounted for its stock options under the intrinsic value method of APB Opinion No. 25, “Accounting for Stock Issued To Employees” and related Interpretations, and applied the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” First Financial’s employee stock options have fixed terms and the exercise price of the stock options equals the market price on the date of grant. Therefore, no compensation cost was recognized for stock options prior to January 1, 2006.

Certain reclassifications of prior year’s amounts have been made to conform to current year presentation. Such reclassifications had no effect on earnings.

On September 16, 2005, First Financial completed the sale of substantially all of the assets and certain liabilities of its Fidelity Federal Savings Bank subsidiary to Mutual Federal Savings Bank, a subsidiary of MutualFirst Financial, Inc. of Muncie, Indiana. Fidelity Federal is reported as a discontinued operation for financial reporting purposes for all prior periods presented. The results of its operations and its cash flows have been removed from First Financial’s results of continuing operations for all periods presented.

The results of Fidelity Federal are presented as discontinued operations in a separate category on the income statement following the results from continuing operations. The income from discontinued operations for the nine months and three months ended September 30, 2005 is as follows:

In the normal course of business, First Financial offers a variety of financial instruments with off-balance sheet risk to its customers to aid them in meeting their requirements for liquidity and credit enhancement and to reduce its own exposure to fluctuations in interest rates. These financial instruments include standby letters of credit and commitments outstanding to extend credit. A discussion of these instruments follows.

First Financial’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit and commitments outstanding to extend credit is represented by the contractual amounts of those instruments. First Financial uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Following is a discussion of these transactions.

Standby letters of credit are conditional commitments issued by First Financial to guarantee the performance of a customer to a third party. First Financial’s portfolio of standby letters of credit consists primarily of performance assurances made on behalf of customers who have a contractual commitment to produce or deliver goods or services. The risk to First Financial arises from its obligation to make payment in the event of the customers’ contractual default. As of September 30, 2006, First Financial had issued standby letters of credit aggregating $25,489 compared to $38,296 issued as of December 31, 2005. Management conducts regular reviews of these instruments on an individual customer basis, and the results are considered in assessing the need to provide for losses. Management does not anticipate any material losses as a result of these letters of credit.

Loan commitments are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. First Financial evaluates each customer’s creditworthiness on an individual basis. The amount of collateral obtained, if deemed necessary by First Financial upon extension of credit, is based on management’s credit evaluation of the counterparty. The collateral held varies, but may include securities, real estate, inventory, plant, or equipment. First Financial had commitments outstanding to extend credit totaling $588,154 at September 30, 2006, and $523,276 at December 31, 2005. Management does not anticipate any material losses as a result of these commitments.

First Financial discloses comprehensive income in the “Consolidated Statements of Changes in Shareholders’ Equity.” Disclosure of the reclassification adjustments for the nine and three months ended September 30, 2006, and 2005 are shown in the table below.

At September 30, 2006, the unfunded pension losses, net of taxes, recorded as accumulated comprehensive income are $7,562.

The use of derivative instruments allows a bank to meet the needs of its customers while reducing the interest-rate risk associated with certain transactions. In 2001, First Financial’s board of directors approved a policy authorizing the use of certain derivative products. The approved derivative instruments included interest rate caps, floors, and swaps. Currently, First Financial utilizes interest rate swaps as a means to offer long-term fixed-rate loans to commercial borrowers while maintaining the variable-rate income that better suits First Financial’s funding position.

First Financial designates its derivatives based upon criteria established by SFAS No. 133, as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment to FASB Statement No. 133,” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” The following table summarizes the derivative financial instruments utilized by First Financial:

Other long-term debt, which appears on the balance sheet, consists of junior subordinated debentures owed to two unconsolidated subsidiary trusts. Capital securities were issued in the third quarter of 2003 by a statutory business trust — First Financial (OH) Statutory Trust II and in the third quarter of 2002 by another statutory business trust — First Financial (OH) Statutory Trust I. First Financial owns 100% of the common equity of both of the trusts. The trusts were formed with the sole purpose of issuing the capital securities and investing the proceeds from the sale of such capital securities in the debentures. The debentures held by the trust are the sole assets of each trust. Distributions on the capital securities are payable quarterly at a variable rate of interest, which is equal to the interest rate being earned by the trust on the debentures and are recorded as interest expense of First Financial. The interest rate is variable and is subject to change every three months. The base index is the three-month LIBOR (London Inter-Bank Offered Rate). On September 30, 2006, the rates on Trust I and Trust II were 8.77% and 8.60%, respectively. First Financial has the option to defer interest for up to five years on the debentures. However, the covenants prevent the payment of dividends on common stock if the interest is deferred. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. First Financial has entered into agreements which, taken collectively, fully or unconditionally guarantee the capital securities subject to the terms of the guarantees. The debentures qualify as Tier I capital under Federal Reserve Board guidelines. The debentures issued in 2003 are first redeemable, in whole or in part, by First Financial on September 30, 2008 and mature on September 30, 2033. The amount outstanding, net of offering costs, as of September 30, 2006, was $20,000. The debentures issued in 2002 are first redeemable, in whole or in part, by First Financial on September 25, 2007, and mature on September 25, 2032. The amount outstanding, net of offering costs, as of September 30, 2006, was $10,000.

First Financial adopted the provisions of SFAS No. 123(R) effective January 1, 2006, using the modified-prospective transition method, which requires measurement of compensation cost for all stock-based awards at fair value on the date of grant and recognition of compensation expense over the service period for awards expected to vest. Share-based compensation expense for stock options and restricted stock awards included in salaries and employee benefits expense for the first nine months of 2006 was $1,306 and for the third quarter of 2006 was $531. Total unrecognized compensation cost related to nonvested share-based compensation was $4,969 at September 30, 2006 and is expected to be recognized over a weighted average period of 2.6 years.

Under the intrinsic method of accounting, compensation expense had not been recognized in the prior year statements of earnings for stock-based compensation plans, other than for restricted stock awards. The following table illustrates the effect on net earnings and earnings per share if First Financial had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation for the nine and three months ended September 30, 2005:

As of September 30, 2006, First Financial had two stock-based compensation plans. The 1991 Stock Incentive Plan provides incentive stock options and stock awards to certain key employees and non-qualified stock options to directors of First Financial who are not employees for up to 1,691,036 common shares of First Financial. The options are not exercisable for at least one year from the date of grant and are thereafter exercisable for such periods (which may not exceed 10 years) as the board of directors, or a committee thereof, specifies, provided that the optionee has remained in the employment of First Financial and its subsidiaries. All options expire at the end of the exercise period, and forfeited or expired options become available for re-issuance. On April 27, 1999, the shareholders approved the 1999 Stock Incentive Plan that provides for 7,507,500 shares for similar awards and options.

The fair value of stock options is determined using the Black-Scholes valuation model. The expected dividend yield is based on historical dividend payouts; the expected volatility is based on historical volatilities of company stock for a period approximating the expected life; the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option; and the expected life represents the period of time the options are expected to be outstanding and is based on historical trends. The weighted average assumptions used in the computations are as follows:

Activity in the above plan for the nine months ended September 30, 2006 is summarized as follows:

Intrinsic value for stock options is defined as the difference between the current market value and the grant price. The total intrinsic value of options exercised during the first nine months of 2006 was $188 and for the third quarter of 2006 was $0. The weighted average grant date fair value of options granted during the first nine months of 2006 was $2.88 and for the third quarter of 2006 was $2.57. Cash received from stock options exercised during the first nine months of 2006 was $254 and for the third quarter of 2006 was $0, and the related tax benefit for tax deductions from stock options and restricted stock expensed for the first nine months of 2006 was $394 and for the third quarter of 2006 was $158. First Financial uses treasury shares purchased under the company’s share repurchase program to satisfy share-based exercises.

Restricted stock awards have historically been recorded as deferred compensation, a component of shareholders’ equity at the fair value of these awards at the grant date and amortized on a straight-line basis to salaries and benefits expense over the specified vesting periods, which is currently four years. For all awards granted prior to 2005 and for awards granted to non-employee directors in 2005 and 2006, the vesting of the awards only required a service period to be met. Therefore, 25% of each grant would vest each of the four years. For restricted stock awards granted to employees in 2005 and 2006, First Financial must meet a performance goal of 12.00% return on equity. Since the return on equity goal was not met in 2005 and the first three quarters of 2006, 25% of the awards granted in 2005 and the first three quarters of 2006 will not vest. However, if the cumulative period average return on equity (grant date through next

measurement date) is 12.00% or higher, the first year’s awards, as well as the second year’s awards, will vest in 2006.

The following is a summary of activity in restricted stock for the nine months ended September 30, 2006:

The fair value of restricted stock is determined based on the number of shares granted and the quoted price of First Financial’s common stock. The total fair value of restricted stock vested during the first nine months of 2006 was $1,089 and for the third quarter of 2006 was $0, as no restricted stock vested during the third quarter of 2006.

First Financial sponsors a non-contributory defined benefit pension plan covering substantially all employees. As of September 30, 2006, First Financial expects to contribute $6,583 to its pension plan in 2006. The following table sets forth information concerning amounts recognized in First Financial’s Consolidated Balance Sheets and Consolidated Statements of Earnings.

Some of First Financial’s subsidiaries maintain health care and, in limited instances, life insurance plans for current retired employees. The following table sets forth the components of net periodic postretirement benefit costs.

Core deposit intangibles are amortized on a straight-line basis over their useful lives. Core deposit balances are being amortized over varying periods, none of which exceeds 10 years.

The sale of 10 branches and closure of 7 offices was completed in August of 2006. The sale of the 10 offices was completed in three separate transactions. Total net gains on sale were $12,545 or $0.20 per share. Total deposits of $108,629 were assumed and total loans of $101,414 were sold. The estimated proforma financial impact of the branch sales and closures, excluding the gain on sales, remains earnings neutral.

First Financial will continue to concentrate future growth plans and capital investments in larger metropolitan markets. Smaller markets have historically provided stable, low-cost funding sources to First Financial and are an important part of its funding plan. First Financial’s historical strength in a number of these markets should enable it to retain market share.

First Financial’s branch strategy is to serve a combination of metropolitan and non-metropolitan markets in Indiana, Ohio, and Kentucky. In addition to geographic fit, each market must have growth potential and the ability to meet profit targets.

Following the completion of the branch plan, First Financial has 87 offices serving 9 distinct markets with an average branch size of approximately $33,000. The operating model for growth includes market presidents managing distinct markets with the authority to make decisions at the point of client contact.

First Financial has entered into an agreement with Jack Henry & Associates Inc. to license their software applications, which will be used to provide primary core data processing. This in-house solution provides First Financial with a more cost-effective model. The conversion to the Jack Henry system was completed in October of 2006, and should enhance First Financial’s capability to deliver client services in a better, faster, and more efficient manner.

This decision is consistent with the strategic plan and is an integral component of First Financial’s comprehensive review of the use of technology. This review includes analysis of our data and voice telecommunication usage, on-line and ATM services, and other ancillary services. Expected savings as a result of this comprehensive review remain between $3,000 and $4,000 per year and should be fully recognized in 2007. Costs associated with this conversion will include the early termination of some existing contracts. To-date, $2,600 in early termination penalties and other one-time charges have been recorded.

Net earnings for the first nine months of 2006 were $20,444 or $0.52 in diluted earnings per share versus $35,099 or $0.81 for the first nine months of 2005. Income from continuing operations for the nine months ended September 30, 2006, was $20,444 or $0.52 in diluted earnings per share versus $27,974 or $0.64 in diluted earnings per share for the same period in 2005. The $7,530 decrease in income from continuing operations was due to several material items: net interest income decreased $6,059; noninterest expense increased $19,213; and provision for loan losses increased $1,444. These decreases were offset by an increase in noninterest income of $17,141. A detailed discussion of these items follows.

Net earnings for the third quarter of 2006 were $12,119 or $0.31 in diluted earnings per share, compared to $14,484 or $0.33 in diluted earnings per share for the third quarter of 2005. Income from continuing operations for the nine months ended September 30, 2006, was $12,119 or $0.31 in diluted earnings per share versus $7,819 or $0.18 in diluted earnings per share for the same period in 2005.

Return on average assets for the third quarter of 2006 was 1.40% compared to 1.50% for the same period in 2005. Return on average shareholders’ equity was 16.09% for the third quarter of 2006, versus 15.64% for the comparable period in 2005. Year-to-date return on average assets was 0.79% for 2006, compared to 1.22% for 2005, while return on equity was 9.18% for 2006 versus 12.71% for 2005.

Third quarter of 2006 noninterest income was $30,429, an increase of $16,420 or 117.21% from the third quarter of 2005. Third quarter of 2006 noninterest income included $12,545 from the gain on the sale of the branches and $2,200 from the gain on the problem loan sale. The third quarter of 2005 included a $1,649 loss associated with the sale of $42,000 in indirect loans. Excluding these items, noninterest income remained flat, increasing $26 or 0.17%, from the third quarter of 2005. First Financial had quarterly increases in service charges on deposit accounts income of $728 which included the positive effects of its new overdraft program. Bankcard interchange income increased $123 due to both increased debit card issuance and usage, while bank-owned life insurance income decreased $155, trust fees decreased $218, and MSR impairment recapture decreased $255.

On a linked-quarter basis (third quarter 2006 compared to second quarter 2006), total noninterest income increased $14,588 or 92.09%. This increase was due to the branch and loan sale gains discussed previously. Excluding these, noninterest income would have decreased $157. This decrease was primarily due to a $354 decrease in bank-owned life insurance, offset by a $241 increase in service charges on deposit accounts related to increases in nonsufficient funds charges.

Year-to-date noninterest income increased $17,141 or 39.06% from the comparable period in 2005. Excluding previously discussed gains in 2006 and loss in 2005, noninterest income would have increased

$747 or 1.64%. This increase is primarily due to increases in service charges on deposit accounts of $2,473 and an increase of $493 in miscellaneous collection fees offset by an $865 decrease in MSR impairment recapture, a $476 loss on investment securities sold, a $343 decrease in bank-owned life insurance income, a $256 decrease in trust fees, and a $246 decrease in investment advisory fees.

Total noninterest expense increased $4,602 or 13.25% for the third quarter of 2006 from the third quarter of 2005. This increase was primarily due to increases of $615 in salaries and benefits, $337 in occupancy expense, $1,282 in data processing expenses, $810 in professional services, $603 in marketing expense, and $1,289 in other noninterest expense, somewhat offset by a decrease in equipment expense of $397. Salaries and benefits increased $615 due to increased severance-related salaries and benefits expense of $503 and an increase in production bonuses of $247. Occupancy expense increased $337 due to increased maintenance costs. The increase in data processing of $1,282 is primarily related to early termination fees of $500 and acceleration of fees of $300 for the conversion of various systems as well as $171 in software license amortization. The increase in professional services of $810 is primarily due to charges associated with the upcoming voice and data telecommunication improvements and with recruiting fees. The $603 increase in marketing expense is primarily associated with the new branding initiative. The increase in other noninterest expense of $1,289 consists of increases in various accounts, including $511 in losses on fixed assets associated with the branch sale and the disposal of personal computers associated with the technology upgrade, approximately $522 in conversion-related travel and supplies, and $181 in credit card and merchant interchange expense that was more than offset by the increase interchange income and merchant discount. The $397 decrease in equipment expense is primarily due to a decrease in equipment expense rent of $108 and service contracts of $156 that are not expected to continue.

On a linked-quarter basis, noninterest expense was $1,362 less than the second quarter. This decrease was due to the offsetting effects of decreases in salaries and benefits of $3,142, decreases in data processing of $335, increases in marketing of $491 primarily due to the branding initiative discussed earlier, and increases in professional services of $606 primarily due to the data and voice telecommunication upgrade discussed previously. Salaries and benefits decreased $3,142 due to decreased severance of $1,905, decreased salaries in period payroll of approximately $185, decreased healthcare of $395, and decreased retirement-related expense of $558. The decrease in data processing of $335 is due to early termination fees paid in the second quarter offset by early termination fees paid in the third quarter.

Year-to-date noninterest expense increased $19,213. Excluding the effects of the $4,295 prepayment penalty recorded in the first quarter of 2006, noninterest expense would have increased $14,918. The increase is due to increases in salaries and benefits of $5,875, occupancy expense of $1,284, data processing of $3,313, professional services of $873, and other noninterest expense of $3,856. Salaries and benefits increased $5,875 due to severance charges of $3,453, retirement-related expense of $1,002, production bonuses of $658, and healthcare of $257. Occupancy expense increased $1,284 due to increased maintenance costs, utilities, and new building rent consistent with First Financial’s growth plans. The $3,313 increase in data processing is primarily due to early termination fees and acceleration of fees discussed previously. The $873 increase in professional services is primarily due to the data and voice telecommunication upgrade discussed previously as well as consulting associated with a branch staffing model. The $3,856 increase in other noninterest expense is due to increases in various accounts, including $799 in travel-related expenses, $706 in state intangible tax, and $589 in credit and collection expense.

Net interest income, First Financial’s principal source of earnings, is the amount by which interest and fees generated by earning assets exceed the interest costs of liabilities obtained to fund them. For analytical purposes, net interest income is also presented in the table that follows, adjusted to a tax equivalent basis assuming a 35% marginal tax rate for interest earned on tax-exempt assets such as municipal loans, tax-free leases, and investments. This is to recognize the income tax savings that facilitates a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully tax equivalent basis. Therefore, management believes these measures provide useful information to investors by allowing them to make peer comparisons. Management also uses these measures to make peer comparisons.

Net interest income for the third quarter of 2006 was $30,823 compared to $33,143 in the third quarter of 2005, a decrease of $2,320 or 7.00%. This decrease is due primarily to a planned reduction in earning assets through loan sales, exit of the indirect line of business, and the strategic decision to sell conforming mortgage loan production in the secondary market; compounded by the increase in deposit costs. Net interest income on a linked-quarter basis decreased $1,124 or 3.52%. Net interest income on a year-to-date basis declined $6,059 or 6.00%, which is primarily due to the continued effects of increased rates on deposits and account migration to higher yielding products.

First Financial’s net interest margin increased to 3.93% in the third quarter of 2006 from 3.83% in the third quarter of 2005. Linked-quarter net interest margin decreased 18 basis points from 4.11% to 3.93% due to the combined effects of the loan mix shift, 3 basis points; commercial loan volume increase, 3 basis points; and other, 2 basis points; offset by the negative effect of the branch sale, 7 basis points; CD portfolio repricing, 12 basis points; and the impact of an increased public fund deposit, 7 basis points. On a year-to-date basis, net interest margin increased 11 basis points from 3.92% in 2005, to 4.03%.

The primary risk to our margin remains unanticipated consumer and competitor behavior in deposit products, specifically the consumer preference for higher-yielding money market accounts rather than more traditional transaction accounts, and the aggressiveness in market pricing for both transaction and certificate of deposit accounts. First Financial is reducing the full year 2006 margin estimate to between 3.95% and 4.00% from a previous estimate of between 4.05% and 4.10%. The reduction is due largely to the effect of a product mix shift in the consumer deposit portfolio.

The Statistical Information that follows is presented on a GAAP basis.