FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from _______ to _______ Commission File Number 0-17071 First Merchants Corporation (Exact name of registrant as specified in its charter) Indiana 35-1544218 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 200 East Jackson Street Muncie, IN 47305-2814 (Address of principal executive offices) (Zip code) (765) 747-1500 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report) 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 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): Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] As of April 18, 2006, there were 18,442,576 outstanding common shares, without par value, of the registrant.
FIRST MERCHANTS CORPORATION FORM 10-Q INDEX Page No. PART I. Financial Information: Item 1. Financial Statements: Consolidated Condensed Balance Sheets........................3 Consolidated Condensed Statements of Income..................4 Consolidated Condensed Statements of Comprehensive Income.........................................5 Consolidated Condensed Statements of Stockholders' Equity.........................................6 Consolidated Condensed Statements of Cash Flows..............7 Notes to Consolidated Condensed Financial Statements.........8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................17 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................................................27 Item 4. Controls and Procedures.....................................27 PART II. Other Information: Item 1. Legal Proceedings...........................................28 Item 1.A. Risk Factors................................................28 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds..............................28 Item 3. Defaults Upon Senior Securities.............................28 Item 4. Submission of Matters to a Vote of Security Holders.........28 Item 5. Other Information...........................................28 Item 6. Exhibits....................................................29 Signatures...................................................................30 Index to Exhibits............................................................31 Page 2
FIRST MERCHANTS CORPORATION FORM 10-Q PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS CONSOLIDATED CONDENSED BALANCE SHEETS (Dollars in thousands, except per share amounts) <TABLE> March 31, December 31, 2006 2005 ------------ ------------ (Unaudited) <S> <C> <C> ASSETS: Cash and due from banks ....................................... $ 59,176 $ 70,417 Interest-bearing deposits...................................... 9,104 8,748 Investment securities available for sale ...................... 431,190 422,627 Investment securities held to maturity ........................ 10,461 11,639 Mortgage loans held for sale................................... 5,170 4,910 Loans, net of allowance for loan losses of $25,623 and $25,188. 2,465,865 2,432,239 Premises and equipment ........................................ 39,029 39,417 Federal Reserve and Federal Home Loan Bank stock............... 23,421 23,200 Interest receivable ........................................... 19,035 19,690 Core deposit intangibles ...................................... 16,805 17,567 Goodwill ...................................................... 121,369 121,266 Cash surrender value of life insurance......................... 43,964 43,579 Other assets .................................................. 25,346 21,780 ----------- ----------- Total assets .............................................. $ 3,269,935 $ 3,237,079 =========== =========== LIABILITIES: Deposits: Noninterest-bearing ......................................... $ 325,548 $ 314,335 Interest-bearing ............................................ 2,120,524 2,068,241 ----------- ----------- Total deposits ............................................ 2,446,072 2,382,576 Borrowings .................................................... 469,002 508,236 Interest payable .............................................. 6,412 5,874 Other liabilities.............................................. 31,711 26,997 ----------- ----------- Total liabilities ......................................... 2,953,197 2,923,683 COMMITMENTS AND CONTINGENT LIABILITIES STOCKHOLDERS' EQUITY: Perferred stock, no-par value: Authorized and unissued - 500,000 shares Common Stock, $.125 stated value: Authorized --- 50,000,000 shares Issued and outstanding - 18,440,316 and 18,416,714 shares.... 2,305 2,302 Additional paid-in capital .................................... 146,374 145,682 Retained earnings ............................................. 177,975 174,717 Accumulated other comprehensive loss .......................... (9,916) (9,305) ----------- ----------- Total stockholders' equity ................................ 316,738 313,396 ----------- ----------- Total liabilities and stockholders' equity ................ $ 3,269,935 $ 3,237,079 =========== =========== </TABLE> See notes to consolidated condensed financial statements. Page 3
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF INCOME (Dollars in thousands, except per share amounts) (Unaudited) <TABLE> Three Months Ended March 31, 2006 2005 <S> <C> <C> Interest Income: Loans receivable Taxable ................................................... $ 43,079 $ 36,822 Tax exempt ................................................ 168 134 Investment securities Taxable ................................................... 2,726 2,329 Tax exempt ................................................ 1,647 1,553 Federal funds sold .......................................... 17 27 Deposits with financial institutions ........................ 114 142 Federal Reserve and Federal Home Loan Bank stock ............ 311 308 -------- -------- Total interest income ..................................... 48,062 41,315 -------- -------- Interest expense: Deposits .................................................... 14,419 9,806 Borrowings .................................................. 6,054 4,567 -------- -------- Total interest expense .................................... 20,473 14,373 -------- -------- Net Interest Income ........................................... 27,589 26,942 Provision for loan losses ..................................... 1,726 2,667 -------- -------- Net Interest Income After Provision for Loan Losses ........... 25,863 24,275 -------- -------- Total other income ............................................ 8,597 9,046 Total other expenses: Salaries and benefits ....................................... 14,392 14,821 Other expenses .............................................. 9,396 9,410 -------- -------- Total other expenses ...................................... 23,788 24,231 Income before income tax ...................................... 10,672 9,090 Income tax expense ............................................ 3,163 2,523 -------- -------- Net Income .................................................... $ 7,509 $ 6,567 ======== ======== Per share: Basic ..................................................... $ .41 $ .35 Diluted ................................................... .41 .35 Dividends ................................................. .23 .23 </TABLE> See notes to consolidated condensed financial statements. Page 4
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands) (Unaudited) <TABLE> Three Months Ended March 31 ---------------------- 2006 2005 --------- --------- <S> <C> <C> Net Income...................................................................... $ 7,509 $ 6,567 Other comprehensive income (loss), net of tax: Unrealized losses on securities available for sale: Unrealized holding losses arising during the period, net of income tax benefit of $407, and $2,522 ................................... (611) (3,783) --------- --------- Comprehensive income ........................................................... $ 6,898 $ 2,784 ========= ========= </TABLE> See notes to consolidated condensed financial statements. Page 5
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands) (Unaudited) <TABLE> <CAPTION> 2006 2005 --------- --------- <S> <C> <C> Balances, January 1 ............................................ $ 313,396 $ 314,603 Net income ..................................................... 7,509 6,567 Cash dividends on common stock ................................. (4,238) (4,264) Cash dividends on restricted stock awards ...................... (13) Other comprehensive income (loss), net of tax................... (611) (3,783) Stock issued under dividend reinvestment and stock purchase plan 291 335 Stock options exercised ........................................ 255 757 Tax benefit from stock options exercised ....................... 24 Stock redeemed ................................................. (69) (3,617) Share-based compensation ....................................... 194 --------- --------- Balances, March 31 ............................................. $ 316,738 $ 310,598 ========= ========= </TABLE> See notes to consolidated condensed financial statements. Page 6
FIRST MERCHANTS CORPORATION FORM 10-Q CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited) <TABLE> Three Months Ended March 31, ------------------------------------ 2006 2005 ---------------- ---------------- <S> <C> <C> Cash Flows From Operating Activities: Net income........................................................................ $ 7,509 $ 6,567 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses....................................................... 1,726 2,667 Depreciation and amortization................................................... 1,323 2,276 Share-based compensation........................................................ 194 Tax benefits from stock options exercised....................................... (24) Mortgage loans originated for sale.............................................. (28,586) (12,840) Proceeds from sales of mortgage loans........................................... 28,326 13,123 Change in interest receivable................................................... 655 712 Change in interest payable...................................................... 538 885 Other adjustments............................................................... 2,000 2,111 ---------------- ---------------- Net cash provided by operating activities..................................... 13,661 15,501 ---------------- ---------------- Cash Flows From Investing Activities: Net change in interest-bearing deposits........................................... (356) (1,394) Purchases of Securities available for sale................................................... (22,781) (11,654) Proceeds from maturities of Securities available for sale................................................... 13,282 16,246 Securities held to maturity..................................................... 949 1,048 Proceeds from sales of securities available for sale.............................. Purchase of Federal Reserve and Federal Home Loan Bank Stock.................................................... (221) (25) Net change in loans............................................................... (35,352) 13,225 Other adjustments................................................................. (935) (510) ---------------- ---------------- Net cash provided (used) by investing activities.............................. (45,414) 16,936 ---------------- ---------------- Cash Flows From Financing Activities: Net change in Demand and savings deposits..................................................... (56,553) (95,211) Certificates of deposit and other time deposits................................. 120,049 139,280 Borrowings........................................................................ 36,150 (49,698) Repayment of borrowings........................................................... (75,384) Cash dividends on common stock.................................................... (4,238) (4,264) Cash dividends on restricted stock awards......................................... (13) Stock issued under dividend reinvestment and stock purchase plan.................. 291 335 Stock options exercised........................................................... 255 757 Tax benefit from stock options exercised.......................................... 24 Stock redeemed.................................................................... (69) (3,617) ---------------- ---------------- Net cash provided (used) by financing activities.............................. 20,512 (12,418) ---------------- ---------------- Net Change in Cash and Cash Equivalents............................................. (11,241) 20,019 Cash and Cash Equivalents, January 1................................................ 70,417 69,960 ---------------- ---------------- Cash and Cash Equivalents, March 31................................................. $ 59,176 $ 89,979 ================ ================ Additional cash flows information: Interest paid .................................................................... $ 19,935 $ 13,488 Income tax paid .................................................................. 500 </TABLE> See notes to consolidated condensed financial statements. Page 7
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 1. General Financial Statement Preparation The significant accounting policies followed by First Merchants Corporation ("Corporation") and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting, except as discussed below within the caption "Change in Accounting Principle". All adjustments, which are of a normal recurring nature and are in the opinion of management necessary for a fair statement of the results for the periods reported, have been included in the accompanying consolidated condensed financial statements. The consolidated condensed balance sheet of the Corporation as of December 31, 2005 has been derived from the audited consolidated balance sheet of the Corporation as of that date. Certain information and note disclosures normally included in the Corporation's annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation's Form 10-K annual report filed with the Securities and Exchange Commission. The results of operations for the three month period ended March 31, 2006 are not necessarily indicative of the results to be expected for the year. Change in Accounting Principle Effective January 1, 2006, the Corporation adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment ("SFAS 123(R)"). SFAS 123(R) addresses all forms of share-based payment awards, including shares under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. SFAS 123(R) requires all share-based payments to be recognized as expense, based upon their fair values, in the financial statements over the vesting period of the awards. The Corporation has elected the modified prospective application and, as a result, has recorded approximately $194,000 in compensation expense related to vested stock options, Employee Stock Purchase Plan options and restricted stock awards, less estimated forfeitures, for the three month period ended March 31, 2006. NOTE 2. Share-Based Compensation Stock options and restricted stock awards ("RSAs") have been issued to directors, officers and other management employees under the Corporation's 1994 Stock Option Plan and The 1999 Long-term Equity Incentive Plan. The stock options, which have a ten year life, become 100 percent vested ranging from three months to two years and are fully exercisable when vested. Option exercise prices equal the Corporation's common stock closing price on NASDAQ on the date of grant. RSAs provide for the issuance of shares of the Corporation's common stock at no cost to the holder and generally vest after three years. The RSAs vest only if the employee is actively employed by the Corporation on the vesting date and, therefore, any unvested shares are forfeited. The Corporation's 2004 Employee Stock Purchase Plan ("ESPP") provides eligible employees of the Corporation and its subsidiaries an opportunity to purchase shares of common stock of the Corporation through annual offerings financed by payroll deductions. The price of the stock to be paid by the employees may not be less than 85 percent of the lesser of the fair market value of the Corporation's common stock at the beginning or at the end of the offering period. Common stock purchases are made annually and are paid through advance payroll deductions of up to 20 percent of eligible compensation. SFAS 123(R) requires the Corporation to begin recording compensation expense in 2006 related to unvested share-based awards outstanding as of December 31, 2005, by recognizing the unamortized grant date fair value of these awards over the remaining service periods of those awards, with no change in historical reported fair values and earnings. Awards granted after December 31, 2005 are valued at fair value in accordance with provisions of SFAS 123(R) and are recognized on a straight-line basis over the service periods of each award. To complete the exercise of vested stock options, RSA's and ESPP options, the Corporation generally issues new shares from its authorized but unissued share pool. At March 31, 2006, share-based compensation for the three months ended March 31, 2006 totaled $194,000, and has been recognized as a component of salaries and benefits expense in the accompanying Consolidated Condensed Statements of Income. Page 8
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 2. Share-Based Compensation continued Prior to 2006, the Corporation accounted for share-based compensation in accordance with APB 25 using the intrinsic value method, which did not require that compensation expense be recognized for the Corporation's stock and ESPP options; however, under APB 25, the Corporation was required to record compensation expense over the vesting period for the value of RSAs granted, if any. The Corporation provided pro forma disclosure amounts in accordance with SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (SFAS No. 148), as if the fair value method defined by SFAS No. 123 had been applied to its share-based compensation. The Corporation's net income and net income per share for the three months ended March 31, 2005 would have been reduced if compensation expense related to stock and ESPP options had been recorded in the financial statements, based on fair value at the grant dates. The estimated fair value of the stock options granted during 2006 and in prior years was calculated using a Black Scholes option pricing model. The following summarizes the assumptions used in the 2006 Black Scholes model: Risk-free interest rate 4.59% Expected price volatility 29.84% Dividend yield 3.54% Forfeiture rate 4.00% Weighted-average expected life, until exercise 5.75 years The Black Scholes model incorporates assumptions to value share-based awards. The risk-free rate of interest, for periods equal to the expected life of the option, is based on a zero-coupon U.S. government instrument over a similar contractual term of the equity instrument. Expected price volatility is based on historical volatility of the Corporation's common stock. In addition, the Corporation generally uses historical information to determine the dividend yield and weighted-average expected life of the options, until exercise. Separate groups of employees that have similar historical exercise behavior with regard to option exercise timing and forfeiture rates are considered separately for valuation and attribution purposes. Share-based compensation expense recognized in the Consolidated Condensed Statements of Income is based on awards ultimately expected to vest and is reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be approximately 4 percent for the three months ended March 31, 2006, based on historical experience. In the Corporation's pro forma disclosures required under SFAS 123(R) for the periods prior to fiscal 2006, the Corporation accounted for forfeitures as they occurred. As a result of adopting SFAS 123(R), net income of the Corporation for the three months ended March 31, 2006 was $161,000 lower (net of $33,000 in tax benefits), than if it had continued to account for share-based compensation under APB 25. The impact on both basic and diluted earnings per share for the three months ended March 31, 2006 was less than $.01 per share. Page 9
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 2. Share-Based Compensation continued Pro forma net income, as if the fair value based method had been applied to all awards, is as follows: (In thousands, except for per share amounts) <TABLE> <CAPTION> Three Months Ended March 31, 2006 2005 ------------------------- <S> <C> <C> Net income as reported ................................................... $ 7,509 $ 6,567 Add: Share-based compensation awards recorded as expense, net of income taxes ................................................. 161 Less: Share-based compensation cost, determined under the fair value based method, net of income taxes .................... (161) (276) ---------- ---------- Pro forma net income ..................................................... $ 7,509 $ 6,291 ========== ========== Earnings per share: Basic - as reported ................................................. $ .41 $ .35 Basic - pro forma ................................................... .41 .34 Diluted - as reported ............................................... .41 .35 Diluted - pro forma ................................................. .41 .34 </TABLE> The following table summarizes the components of the Corporation's share-based compensation awards recorded as expense: <TABLE> <CAPTION> Three Months Ended March 31, 2006 ----------- <S> <C> Stock and ESPP Options: Pre-tax compensation expense ........................................$ 136 Income tax benefit .................................................. (12) ---------- Stock and ESPP option expense, net of income taxes .......................$ 124 ========== Restricted Stock Awards: Pre-tax compensation expense ........................................$ 58 Income tax benefit .................................................. (21) ---------- Restricted stock awards expense, net of income taxes .....................$ 37 ========== Total Share-Based Compensation: Pre-tax compensation expense ........................................$ 194 Income tax benefit .................................................. (33) ---------- Total share-based compensation expense, net of income taxes ..............$ 161 ========== </TABLE> Page 10
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 2. Share-Based Compensation continued As of March 31, 2006, unrecognized compensation expense related to stock options, RSAs and ESPP options totaling $437,000, $1,219,000 and $53,000, respectively, is expected to be recognized over weighted-average periods of 1.60, 2.83 and .25 years, respectively. Stock option activity under the Corporation's stock option plans as of March 31, 2006 and changes during the three months ended March 31, 2006 were as follows: <TABLE> <CAPTION> Weighted- Average Weighted- Remaining Number Average Contractual Aggregate of Exercise Term Intrinsic Shares Price (in Years) Value ---------- ------------ ----------- ---------- <S> <C> <C> <C> <C> Outstanding at January 1, 2006 .................. 1,104,787 $ 23.28 Granted ......................................... 74,570 25.14 Exercised ....................................... (13,929) 16.89 Cancelled ....................................... (217) 26.27 ---------- Outstanding at March 31, 2006 ................... 1,165,211 $ 23.48 6.35 $2,814,000 ========== Vested and Expected to Vest at March 31, 2006.... 1,159,772 $ 23.47 .11 $2,812,000 Exercisable at March 31, 2006 ................... 1,079,140 $ 23.34 6.08 $2,787,000 </TABLE> The weighted-average grant date fair value was $6.15 for stock options granted during the three months ended March 31, 2006. The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Corporation's closing stock price on the last trading day of the first quarter of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their stock options on March 31, 2006. The amount of aggregate intrinsic value will change based on the fair market value of the Corporation's common stock. The aggregate intrinsic value of stock options exercised during first quarter 2006 was $130,000. Exercise of options during this same period resulted in cash receipts of $166,000. The Corporation recognized a tax benefit of approximately $24,000 in the first quarter 2006, related to the exercise of employee stock options and has been recorded as an increase to additional paid-in capital. The following table summarizes information on unvested restricted stock awards outstanding as of March 31, 2006: <TABLE> <CAPTION> Weighted-Average Number of Grant-Date Fair Shares Value ---------- ----------- <S> <C> <C> Unvested RSAs at January 1, 2006 ............. 0 0 Granted ...................................... 58,167 $ 25.10 Forfeited .................................... Vested ....................................... ---------- Unvested RSAs at March 31, 2006 .............. 58,167 $ 25.10 ========== </TABLE> Page 11
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 2. Share-Based Compensation continued The grant date fair value of ESPP options was estimated at the beginning of the July 1, 2005 offering period and approximates $212,000. The ESPP options vest during the twelve month period ending June 30, 2006. At March 31, 2006, total unrecognized compensation expense related to unvested ESPP options was $53,000, which is expected to be recognized over a period of three months. <TABLE> NOTE 3. Investment Securities Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value <S> <C> <C> <C> <C> Available for sale at March 31, 2006 U.S. Treasury ........................ $ 1,595 $ (1) $ 1,594 U.S. Government-sponsored agency securities................... 94,737 $ 23 (2,036) 92,724 State and municipal .................. 162,593 2,075 (1,244) 163,424 Mortgage-backed securities ........... 169,542 106 (6,247) 163,401 Marketable equity securities.......... 10,423 (376) 10,047 -------- -------- -------- -------- Total available for sale ......... 438,890 2,204 (9,904) 431,190 -------- -------- -------- -------- Held to maturity at March 31, 2006 State and municipal................... 10,437 306 (338) 10,405 Mortgage-backed securities............ 24 24 -------- -------- -------- -------- Total held to maturity ........... 10,461 306 (338) 10,429 -------- -------- -------- -------- Total investment securities ...... $449,351 $ 2,510 $(10,242) $441,619 ======== ======== ======== ======== </TABLE> <TABLE> <CAPTION> Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value <S> <C> <C> <C> <C> Available for sale at December 31, 2005 U.S. Treasury ........................ $ 1,586 $ (1) $ 1,585 U.S. Government-sponsored agency securities .................. 83,026 $ 1 (1,836) 81,191 State and municipal .................. 167,095 2,159 (1,131) 168,123 Mortgage-backed securities ........... 168,019 139 (5,656) 162,502 Other asset-backed securities......... 1 1 Marketable equity securities ......... 9,660 (435) 9,225 -------- -------- -------- -------- Total available for sale .......... 429,387 2,299 (9,059) 422,627 -------- -------- -------- -------- Held to maturity at December 31, 2005 State and municipal .................. 11,609 283 (412) 11,480 Mortgage-backed securities ........... 30 30 -------- -------- -------- -------- Total held to maturity ............ 11,639 283 (412) 11,510 -------- -------- -------- -------- Total investment securities ....... $441,026 $ 2,582 $ (9,471) $434,137 ======== ======== ======== ======== </TABLE> Page 12
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 4. Loans and Allowance <TABLE> March 31, December 31, 2006 2005 ----------- ----------- <S> <C> <C> Loans: Commercial and industrial loans .............................................. $ 486,411 $ 461,102 Agricultural production financing and other loans to farmers ................. 87,433 95,130 Real estate loans: Construction ............................................................... 175,784 174,783 Commercial and farmland .................................................... 743,905 734,865 Residential ................................................................ 746,410 751,217 Individuals' loans for household and other personal expenditures ............. 202,478 200,139 Tax-exempt loans ............................................................. 13,656 8,263 Lease financing receivables, net of unearned income........................... 8,193 8,713 Other loans .................................................................. 27,218 23,215 ----------- ----------- 2,491,488 2,457,427 Allowance for loan losses..................................................... (25,623) (25,188) ----------- ----------- Total Loans............................................................... $ 2,465,865 $ 2,432,239 =========== =========== Three Months Ended March 31, 2006 2005 ----------- ----------- Allowance for loan losses: Balances, January 1 .......................................................... $ 25,188 $ 22,548 Provision for losses ......................................................... 1,726 2,667 Recoveries on loans .......................................................... 308 222 Loans charged off ............................................................ (1,599) (949) ----------- ----------- Balances, March 31 ........................................................... $ 25,623 $ 24,488 =========== =========== </TABLE> Information on nonaccruing, contractually past due 90 days or more other than nonaccruing and restructured loans is March 31, December 31, summarized below: 2006 2005 ================================================================================ Non-accrual loans................................ $ 11,424 $ 10,030 Loans contractually past due 90 days or more other than nonaccruing................. 5,188 3,965 Restructured loans............................... 114 310 -------- -------- Total........................................ $ 16,726 $ 14,305 ======== ======== Page 13
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) NOTE 5. Net Income Per Share Basic net income per share is computed by dividing net income by the weighted- average shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the combination of all dilutive common share equivalents, comprised of shares issuable under the Corporation's share-based compensation plans, and the weighted-average shares outstanding during the reporting period. Dilutive common share equivalents include the dilutive effect of in-the-money share-based awards, which are calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of share-based awards, the amount of compensation expense, if any, for future service that the Corporation has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in-captial when share-based awards are exercised, are assumed to be used to repurchase common stock in the current period. <TABLE> Three Months Ended March 31, 2006 2005 ------------------------------------------- ------------------------------------------ Weighted- Weighted- Net Average Per Share Net Average Per Share Income Shares Amount Income Shares Amount ------ ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> <C> Basic net income per share: Net income available to common stockholders......................$ 7,509 18,425,047 $ .41 $ 6,567 18,559,664 $ .35 ========== ========== Effect of dilutive common share equivalents .......................... 107,089 136,862 ---------- ------------ ---------- ------------ Diluted net income per share: Net income available to common stockholders and assumed conversions..................$ 7,509 18,532,136 $ .41 $ 6,567 18,696,526 $ .35 ========== ============ ========== ========== ============ ========== </TABLE> Stock options to purchase 397,339 and 152,158 shares for the three months ended March 31, 2006 and 2005 were not included in the earnings per share calculation because the exercise price exceeded the average market price. Page 14
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) Note 6. Defined Benefit Pension Costs The Corporation has defined benefit pension plans covering substantially all employees. The plans provide benefits that are based on the employees' compensation and years of service. The Corporation uses an actuarial calculation to determine pension plan costs and paid no contributions to its defined-benefit pension plans during the first quarter of 2006. In January 2005, the Board of Directors of the Corporation approved the curtailment of the accumulation of defined benefits for future services provided by certain participants in the First Merchants Corporation Retirement Pension Plan (the "Plan"). Employees of the Corporation and certain of its subsidiaries who are participants in the Plan were notified that, on and after March 1, 2005, no additional pension benefits will be earned by employees who have not both attained the age of fifty-five (55) and accrued at least ten (10) years of "Vesting Service". As a result of this action, the Corporation recorded a $1,630,000 pension curtailment loss to record previously unrecognized prior service costs in accordance with SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits." This loss was recognized and recorded by the Corporation in the first quarter of 2005. The following represents the pension cost for the three months ended March 31, 2006. <TABLE> <CAPTION> Three Months Ended March 31, 2006 2005 ------------------------- Pension Cost - ------------ <S> <C> <C> Service cost............................................ $ 131 $ 145 Interest cost .......................................... 683 658 Expected return on plan assets ......................... (728) (768) Amortization of the transition asset.................... (7) Amortization of prior service cost...................... 1 1 Amortization of the net loss............................ 87 24 Curtailment loss........................................ 1,630 ---------- ---------- Total Pension Cost................................ $ 174 $ 1,683 ========== ========== </TABLE> Page 15
FIRST MERCHANTS CORPORATION FORM 10-Q NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Table dollars in thousands) (Unaudited) Note 7. Impact of Accounting Changes In March 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 156 ("SFAS No. 156"). This Statement amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to initially recognize a servicing asset or servicing liability at fair value each time it undertakes an obligation to service a financial asset by entering into a servicing contract in other specific situations. In addition, SFAS No. 156 permits an entity to choose either of the following subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities: o Amortization method- Amortize servicing assets or servicing liabilities in proportion to and over the 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. o Fair value measurement method- 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. SFAS No. 156 is effective for the Corporation at the beginning of its first fiscal year that begins after September 15, 2006, and should be applied prospectively for recognition and initial measurement of servicing assets and servicing liabilities. Earlier adoption is permitted as of the beginning of an entity's fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. The Corporation did not early adopt SFAS No. 156 on January 1, 2006. The Corporation is currently evaluating the effect of adoption of this Statement on its financial condition and results of operations. Page 16
FIRST MERCHANTS CORPORATION FORM 10-Q Item 2. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations - -------------- FORWARD-LOOKING STATEMENTS We from time to time include forward-looking statements in our oral and written communication. We may include forward-looking statements in filings with the Securities and Exchange Commission, such as this Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of these safe harbor provisions. Forward-looking statements can often be identified by the use of words like "believe", "continue", "pattern", "estimate", "project", "intend", "anticipate", "expect" and similar expressions or future or conditional verbs such as "will", "would", "should", "could", "might", "can", "may", or similar expressions. These forward-looking statements include: * statements of our goals, intentions and expectations; * statements regarding our business plan and growth strategies; * statements regarding the asset quality of our loan and investment portfolios; and * estimates of our risks and future costs and benefits. These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors which could affect the actual outcome of future events: * fluctuations in market rates of interest and loan and deposit pricing, which could negatively affect our net interest margin, asset valuations and expense expectations; * adverse changes in the economy, which might affect our business prospects and could cause credit-related losses and expenses; * adverse developments in our loan and investment portfolios; * competitive factors in the banking industry, such as the trend towards consolidation in our market; * changes in the banking legislation or the regulatory requirements of federal and state agencies applicable to bank holding companies and banks like our affiliate banks; * acquisitions of other businesses by us and integration of such acquired businesses; * changes in market, economic, operational, liquidity, credit and interest rate risks associated with our business; and * the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends. Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward- looking statements. In addition, our past results of operations do not necessarily indicate our anticipated future results. Page 17
FIRST MERCHANTS CORPORATION FORM 10-Q Item 2. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations continued - ------------------------ CRITICAL ACCOUNTING POLICIES Generally accepted accounting principles are complex and require us to apply significant judgments to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurement is not possible or practical. For a complete discussion of our significant accounting policies, see "Notes to the Consolidated Financial Statements" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2005. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements. We have reviewed the application of these policies with the Audit Committee of our Board of Directors. We believe there have been no significant changes during the quarter ended March 31, 2006 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2005. BUSINESS SUMMARY We are a financial holding company headquartered in Muncie, Indiana. Since our organization in 1982, we have grown to include 8 affiliate banks with 65 locations in 17 Indiana and 3 Ohio counties. In addition to our branch network, our delivery channels include ATMs, check cards, interactive voice response systems and internet technology. Our business activities are currently limited to one significant business segment, which is community banking. Our financial service affiliates include eight nationally chartered banks: First Merchants Bank, N.A., The Madison Community Bank, N.A., United Communities National Bank, First National Bank, Decatur Bank and Trust Company, N.A., Frances Slocum Bank & Trust Company, N.A., Lafayette Bank and Trust Company, N.A. and Commerce National Bank. The banks provide commercial and retail banking services. In addition, our trust company, multi-line insurance company and title company provide trust asset management services, retail and commercial insurance agency services and title services, respectively. We believe that our mission, guiding principles and strategic initiatives produce profitable growth for stockholders. Our vision is to satisfy all the financial needs of our customers, help them succeed financially and be recognized as the premier financial services company in our markets. Our primary strategy to achieve this vision is to increase product usage and focus on providing each customer with all of the financial products that fulfill their needs. Our cross-sell strategy and diversified business model facilitate growth in strong and weak economic cycles. We believe it is important to maintain a well controlled environment as we continue to grow our businesses. Sound credit policies are maintained and interest rate and market risks inherent in our asset and liability balances are managed within prudent ranges, while ensuring adequate liquidity and funding. Our stockholder value has continued to increase due to customer satisfaction and the balanced way we manage our business risk. RESULTS OF OPERATIONS Net income for the three months ended March 31, 2006, equaled $7,509,000, compared to $6,567,000 in the same period of 2005. Diluted earnings per share were $.41, an increase of 17.1 percent from the $.35 reported for the first quarter 2005. The increase in earnings during the period is due to an increase in net interest income, a decrease in the provision for loan losses, and a pension accounting loss recorded in the first quarter 2005, resulting from the curtailment of the accumulation of defined benefits in the Corporation's defined benefit plan. These factors are discussed within the respective sections of Management's Discussion and Analysis of Financial Condition and Results of Operations. Annualized returns on average assets and average stockholders' equity for the three months ended March 31, 2006, were .93 percent and 9.49 percent, respectively, compared with .83 percent and 8.33 percent for the same period of 2005. Page 18
FIRST MERCHANTS CORPORATION FORM 10-Q Item 2. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations continued - ------------------------ CAPITAL Our regulatory capital continues to exceed regulatory "well capitalized" standards. Tier I regulatory capital consists primarily of total stockholders' equity and subordinated debentures issued to business trusts categorized as qualifying borrowings, less non-qualifying intangible assets and unrealized net securities gains. Our Tier I capital to average assets ratio was 7.8 percent at March 31, 2006 and 7.7 percent at year end 2005. In addition, at March 31, 2006, we had a Tier I risk-based capital ratio of 9.7 percent and total risk-based capital ratio of 11.7 percent. Regulatory capital guidelines require a Tier I risk-based capital ratio of 4.0 percent and a total risk-based capital ratio of 8.0 percent. Our GAAP capital ratio, defined as total stockholders' equity to total assets, equaled 9.7 percent at March 31, 2006 and December 31, 2005. When we acquire other companies for stock, GAAP capital increases by the entire amount of the purchase price. Our tangible capital ratio, defined as total stockholders' equity less intangibles net of tax to total assets less intangibles net of tax, equaled 5.9 percent as of March 31, 2006, and 5.8 percent at December 31, 2005. We believe that all of the above capital ratios are meaningful measurements for evaluating our safety and soundness. Additionally, we believe the following table is also meaningful when considering our performance measures. The table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures. March 31, December 31, (Dollars in thousands) 2006 2005 Average Goodwill .......................... $ 121,369 $ 120,867 Average Core Deposit Intangible (CDI) ..... 17,171 19,087 Average Deferred Tax on CDI ............... (6,237) (7,141) ----------- ----------- Intangible Adjustment ................... $ 132,303 $ 132,813 =========== =========== Average Stockholders' Equity (GAAP Capital) $ 316,629 $ 315,907 Intangible Adjustment ..................... (132,303) (132,813) ----------- ----------- Average Tangible Capital ................ $ 184,326 $ 183,094 =========== =========== Average Assets ............................ $ 3,235,933 $ 3,195,784 Intangible Adjustment ..................... (132,303) (132,813) ----------- ----------- Average Tangible Assets ................. $ 3,103,630 $ 3,062,971 =========== =========== Net Income ................................ $ 7,509 $ 30,239 CDI Amortization, net of tax .............. 480 1,952 ----------- ----------- Tangible Net Income ..................... $ 7,989 $ 32,191 =========== =========== Diluted Earnings per Share ................ $ 0.41 $ 1.63 Diluted Tangible Earnings per Share ....... $ 0.43 $ 1.73 Return on Average GAAP Capital ............ 9.49% 9.58% Return on Average Tangible Capital ........ 17.34% 17.58% Return on Average Assets .................. 0.93% 0.95% Return on Average Tangible Assets ......... 1.03% 1.05% Page 19
FIRST MERCHANTS CORPORATION FORM 10-Q ASSET QUALITY/PROVISION FOR LOAN LOSSES Our primary business focus is middle market commercial and residential real estate, auto and small consumer lending, which results in portfolio diversification. We ensure that appropriate methods to understand and underwrite risk are utilized. Commercial loans are individually underwritten and judgmentally risk rated. They are periodically monitored and prompt corrective actions are taken on deteriorating loans. Retail loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis. The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The amount provided for loan losses and the determination of the adequacy of the allowance are based on a continuous review of the loan portfolio, including an internally administered loan "watch" list and an ongoing loan review. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified. At March 31, 2006, non-performing loans totaled $16,726,000, an increase of $2,421,000 from December 31, 2005, as noted in Note 4. Loans and Allowance, included within the Notes to Consolidated Condensed Financial Statements of this Form 10-Q. This increase was primarily due to one commercial loan credit added to non-performing loans, during the first quarter of 2006. At March 31, 2006, impaired loans totaled $54,295,000, an increase of $1,915,000 from December 31, 2005. At March 31, 2006, an allowance for losses was not deemed necessary for impaired loans totaling $44,795,000, but an allowance of $3,523,000 was recorded for the remaining balance of impaired loans of $9,500,000 and is included in our allowance for loan losses. At December 31, 2005, impaired loans totaled $52,380,000, an increase of $2,969,000 from year end 2004. At December 31, 2005, a specific allowance for losses was not deemed necessary for impaired loans totaling $44,840,000, but a specific allowance of $2,824,000 was recorded for the remaining balance of impaired loans of $7,540,000 and is included in our allowance for loan losses. The average balance of impaired loans for 2005 was $44,790,000. The increase of total impaired loans is primarily due to the increase of performing, substandard classified loans, which comprise a portion of the total impaired loans. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected. For the Corporation, all performing, substandard classified loans are included in the impaired loan total. At March 31, 2006, the allowance for loan losses was $25,623,000, an increase of $435,000 from year end 2005. As a percent of loans, the allowance was 1.03 percent at March 31, 2006 and 1.02 percent at December 31, 2005. The provision for loan losses for the first three months of 2006 was $1,726,000, a decrease of $941,000 from $2,667,000 for the same period in 2005. Page 20
FIRST MERCHANTS CORPORATION FORM 10-Q LIQUIDITY Liquidity management is the process by which we ensure that adequate liquid funds are available for us and our subsidiaries. These funds are necessary in order for us and our subsidiaries to meet financial commitments on a timely basis. These commitments include withdrawals by depositors, funding credit obligations to borrowers, paying dividends to shareholders, paying operating expenses, funding capital expenditures, and maintaining deposit reserve requirements. Liquidity is monitored and closely managed by the asset/liability committees at each subsidiary and by our asset/liability committee. Our liquidity is dependent upon our receipt of dividends from our bank subsidiaries, which are subject to certain regulatory limitations and access to other funding sources. Liquidity of our bank subsidiaries is derived primarily from core deposit growth, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability-funded liquidity for both the long- term and short-term is deposit growth and retention in the core deposit base. In addition, we utilize advances from the Federal Home Loan Bank. ("FHLB") and a revolving line of credit with LaSalle Bank, N.A. as funding sources. At March 31, 2006, total borrowings from the FHLB were $225,640,000. Our bank subsidiaries have pledged certain mortgage loans and certain investments to the FHLB. The total available remaining borrowing capacity from the FHLB at March 31, 2006, was $82,557,000. At March 31, 2006, our revolving line of credit had a balance of $13,000,000 and a remaining borrowing capacity of $7,000,000. The principal source of asset-funded liquidity is investment securities classified as available-for-sale, the market values of which totaled $431,190,000 at March 31, 2006, an increase of $8,563,000 or 2.0 percent over December 31, 2005. Securities classified as held-to-maturity that are maturing within a short period of time can also be a source of liquidity. Securities classified as held-to-maturity and that are maturing in one year or less totaled $674,000 at March 31, 2006. In addition, other types of assets such as cash and due from banks, federal funds sold and securities purchased under agreements to resell, and loans and interest-bearing deposits with other banks maturing within one year are sources of liquidity. In the normal course of business, we are a party to a number of other off-balance sheet activities that contain credit, market and operational risk that are not reflected in whole or in part in our consolidated financial statements. Such activities include: traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt. We provide customers with off-balance sheet credit support through loan commitments and standby letters of credit. Summarized credit-related financial instruments at March 31, 2006 are as follows: At March 31, (Dollars in thousands) 2006 ================================================================================ Amounts of commitments: Loan commitments to extend credit ............................... $ 617,967 Standby letters of credit ....................................... 31,266 ---------- $ 649,233 ========== Since many of the commitments are expected to expire unused or be only partially used, the total amount of unused commitments in the preceding table does not necessarily represent future cash requirements. In addition to owned banking facilities, we have entered into a number of long-term leasing arrangements to support our ongoing activities. The required payments under such commitments and long-term debt at March 31, 2006 are as follows: <TABLE> <CAPTION> 2006 2007 2008 2009 2010 2011 Total (Dollars in thousands) remaining and after ======================================================================================================= <S> <C> <C> <C> <C> <C> <C> <C> Operating leases ......... $ 1,542 $ 1,756 $ 1,275 $ 1,111 $ 1,057 $ 1,649 $ 8,390 Long-term debt ........... 172,741 45,495 32,806 13,378 35,179 169,403 469,002 -------- -------- -------- -------- -------- -------- -------- Total .................... $174,283 $ 47,251 $ 34,081 $ 14,489 $ 36,236 $171,052 $477,392 ======== ======== ======== ======== ======== ======== ======== </TABLE> Page 21
FIRST MERCHANTS CORPORATION FORM 10-Q INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK Asset/Liability Management has been an important factor in our ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor our liquidity and interest sensitivity positions at regular meetings to review how changes in interest rates may affect earnings. Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, our exposure to changes in net interest income given various rate scenarios and the economic and competitive environments. It is our objective to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal our Asset Liability function to provide optimum and stable net interest income. To accomplish this, we use two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are both constructed, presented, and monitored quarterly. We believe that our liquidity and interest sensitivity position at March 31, 2006, remained adequate to meet our primary goal of achieving optimum interest margins while avoiding undue interest rate risk. We place our greatest credence in net interest income simulation modeling. The GAP/Interest Rate Sensitivity Report is believed by our management to have two major shortfalls. The GAP/Interest Rate Sensitivity Report fails to precisely gauge how often an interest rate sensitive product reprices, nor is it able to measure the magnitude of potential future rate movements. Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. Our asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a 12-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent our view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into our earnings. The base scenario is highly dependent on numerous assumptions embedded in the model, including assumptions related to future interest rates. While the base sensitivity analysis incorporates our best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For mortgage-related assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity products, e.g., savings, money market, NOW and demand deposits, reflect our best estimate of expected future behavior. Page 22
FIRST MERCHANTS CORPORATION FORM 10-Q The comparative rising and falling scenarios for the period ended February 28, 2007 assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by us in the base simulation for the period ended February 28, 2007 are as follows: Driver Rates RISING FALLING ============================================================= Prime 200 Basis Points (200) Basis Points Federal Funds 200 (200) One-Year CMT 200 (200) Two-Year CMT 200 (200) Three-Year CMT 200 (200) Five-Year CMT 200 (200) CD's 200 (59) FHLB Advances 200 (200) Results for the base, rising and falling interest rate scenarios are listed below, based upon our rate sensitive assets and liabilities at February 28, 2006. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. BASE RISING FALLING (Dollars in thousands) ========================================================================= Net Interest Income $110,882 $112,447 $100,249 Variance from base $ 1,565 $(10,633) Percent of change from base 1.41% (9.59)% The comparative rising and falling scenarios for the period ended December 31, 2006 assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by us in the base simulation for the period ended December 31, 2006 are as follows: Driver Rates RISING FALLING ============================================================= Prime 200 Basis Points (200) Basis Points Federal Funds 200 (200) One-Year CMT 200 (200) Two-Year CMT 200 (200) Three-Year CMT 200 (200) Five-Year CMT 200 (200) CD's 200 (89) FHLB Advances 200 (200) Results for the base, rising and falling interest rate scenarios are listed below, based upon our rate sensitive assets and liabilities at November 30, 2005. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations. BASE RISING FALLING (Dollars in thousands) ========================================================================= Net Interest Income $111,989 $114,930 $109,220 Variance from base $ 2,941 $ (2,769) Percent of change from base 2.63% (2.47)% Page 23
FIRST MERCHANTS CORPORATION FORM 10-Q EARNING ASSETS The following table presents the earning asset mix as of March 31, 2006, and December 31, 2005. Loans increased approximately $34,321,000 from December 31, 2005 to March 31, 2006, and investment securities increased by approximately $7,385,000 during the same period. Real estate construction, real estate commercial and farmland, commercial and industrial loans, tax exempt loans and other loans increased approximately $47,085,000 during the first three months of 2006 as compared to the balances outstanding at December 31, 2005. These increases were offset by a $12,764,000 decline in agricultural loans, residential real estate loans and leases. <TABLE> - ---------------------------------------------------------------------------------------------------- EARNING ASSETS (Dollars in thousands) March 31, December 31, 2006 2005 - ---------------------------------------------------------------------------------------------------- <S> <C> <C> Interest-bearing time deposits ...................... $ 9,104 $ 8,748 Investment securities available for sale ............ 431,190 422,627 Investment securities held to maturity .............. 10,461 11,639 Mortgage loans held for sale ........................ 5,170 4,910 Loans ............................................... 2,491,488 2,457,427 Federal Reserve and Federal Home Loan Bank stock 23,421 23,200 ---------- ---------- Total .......................... $2,970,834 $2,928,551 ========== ========== </TABLE> - -------------------------------------------------------------------------------- DEPOSITS AND BORROWINGS The table below reflects the level of deposits and borrowed funds (federal funds purchased; repurchase agreements; Federal Home Loan Bank advances; and subordinated debentures, revolving credit lines and term loans) based on period ending amounts as of March 31, 2006 and December 31, 2005. (Dollars in thousands) March 31, December 31, 2006 2005 ---------- ---------- Deposits ........................................ $2,446,072 $2,382,576 Federal funds purchased.......................... 64,150 50,000 Securities sold under repurchase agreements...... 77,256 106,415 Federal Home Loan Bank advances ................. 225,640 247,865 Subordinated debentures, revolving credit lines and term loans................................ 101,956 103,956 ---------- ---------- $2,915,074 $2,890,812 ========== ========== We have continued to leverage our capital position with Federal Home Loan Bank advances, as well as repurchase agreements which are pledged against acquired investment securities as collateral for the borrowings. The interest rate risk is included as part of our interest simulation discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations under the headings "LIQUIDITY" and "INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK". Page 24
FIRST MERCHANTS CORPORATION FORM 10-Q NET INTEREST INCOME Net Interest Income is the primary source of our earnings. It is a function of net interest margin and the level of average earning assets. The table below presents our asset yields, interest expense, and net interest income as a percent of average earning assets for the three months ended March 31, 2006 and 2005. During the three months ended March 31, 2006, asset yields increased 74 basis points (FTE) and interest costs increased 76 basis points, resulting in a two basis point (FTE) decrease in net interest income as compared to the same period in 2005. The increases in interest income and interest expense were primarily a result of seven 25 basis point overnight federal funds rate increases by the Federal Open Market Committee during this period. <TABLE> <CAPTION> Three Months Ended March 31, <S> <C> <C> (Dollars in thousands) 2006 2005 Annualized Net Interest Income........................ $ 110,356 $ 107,768 Annualized FTE Adjustment............................. $ 3,910 $ 3,634 Annualized Net Interest Income On a Fully Taxable Equivalent Basis................. $ 114,267 $ 111,402 Average Earning Assets................................ $2,953,290 $2,866,551 Interest Income (FTE) as a Percent of Average Earning Assets........................... 6.64% 5.90% Interest Expense as a Percent of Average Earning Assets........................... 2.77% 2.01% Net Interest Income (FTE) as a Percent of Average Earning Assets........................... 3.87% 3.89% Average earning assets include the average balance of securities classified as available for sale, computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. In addition, annualized amounts are computed utilizing a 30/360 day basis. </TABLE> Page 25
FIRST MERCHANTS CORPORATION FORM 10-Q OTHER INCOME Other income in the first three months of 2006 was $449,000 or 5.0 percent lower than the same period of 2005. Three items primarily account for the change: 1. We realized an increase of $318,000 in debit card fees due to greater usage by customers. 2. Service charges in the first quarter of 2006 were $297,000 lower than the same period in 2005. 3. A cash payment was received in the first quarter of 2005 of approximately $232,000, related to our membership in a credit card network that was merged with another card network. No such payment was received during the same period in 2006. OTHER EXPENSES Other expenses in the first three months of 2006 was $443,000 or 1.8 percent lower than the same period in 2005. Two areas account for most of the change: 1. A pension accounting loss, totaling approximately $1,630,000, was recorded during the first quarter of 2005. The loss resulted from the curtailment of the accumulation of defined benefits in our defined benefit pension plan. 2. Salary expenses were $1,033,000 higher in the first quarter of 2006, as compared to the same period in 2005, primarily due to staff additions and normal annual increases. In addition, salary expenses of $194,000 were recorded in the first quarter of 2006, due to share-based compensation expense recorded. Page 26
FIRST MERCHANTS CORPORATION FORM 10-Q INCOME TAXES Income tax expense, for the three months ended March 31, 2006, increased by $640,000 from the same period in 2005. The effective tax rate was 29.6 and 27.8 percent for the 2006 and 2005 periods. OTHER The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including us, and that address is (http://www.sec.gov). Item 3. Quantitative and Qualitative Disclosures About Market Risk - ------------------------------------------------------------------- The information required under this item is included as part of Management's Discussion and Analysis of Financial Condition and Results of Operations, under the headings "LIQUIDITY" and "INTEREST SENSITIVITY AND DISCLOSURES ABOUT MARKET RISK". Item 4. Controls and Procedures - ------------------------------------------------------------------- At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. There have been no changes in our internal controls over financial reporting identified in connection with the evaluation referenced above that occurred during our last fiscal quarter that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 27
FIRST MERCHANTS CORPORATION FORM 10-Q PART II. OTHER INFORMATION Item 1. Legal Proceedings - --------------------------- None Item 1.A. Risk Factors - ---------------------- There have been no material changes from the risk factors previously disclosed in the Corporation's December 31, 2005 Annual Report on Form 10-K. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds - --------------------------------------------------- a. None b. None c. Issuer Purchases of Equity Securities The following table presents information relating to our purchases of equity securities during the quarter ended March 31, 2006, as follows(1): <TABLE> <CAPTION> MAXIMUM NUMBER OF TOTAL NUMBER OF SHARES THAT MAY YET TOTAL NUMBER OF AVERAGE PRICE SHARES PURCHASED AS PART BE PURCHASED UNDER PERIOD SHARES PURCHASED PAID PER SHARE OF BOARD AUTHORIZATION(1) BOARD AUTHORIZATION(1) ------ ---------------- -------------- ------------------------- ------------------------ <S> <C> <C> <C> <C> 01/01/06 - 01/31/06 2,648(2) $26.85 0 0 02/01/06 - 02/28/06 0 0 0 0 03/01/06 - 03/31/06 0 0 0 0 </TABLE> (1) On February 14, 2006, the Corporation's Board authorized management to repurchase up to 250,000 shares of the Corporation's Common Stock. This authorization was not publicly announced and expires February 13, 2007. There were 250,000 remaining shares that may yet be purchased pursuant to such authorizations as of March 31, 2006. (2) These shares were purchased in connection with the exercise of certain outstanding stock options. Item 3. Defaults Upon Senior Securities - ---------------------------------------- None Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------ None Item 5. Other Information - -------------------------- a. None b. None Page 28
FIRST MERCHANTS CORPORATION FORM 10-Q PART II. OTHER INFORMATION Item 6. Exhibits - ----------------------------------------- Exhibit No.: Description of Exhibit: Form 10-Q Page No.: ------------ ------------------------- ------------------- 31.1 Certification of Chief 32 Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 31.2 Certification of Chief 33 Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 32 Certifications Pursuant to 34 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Page 29
FIRST MERCHANTS CORPORATION FORM 10-Q 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 Merchants Corporation --------------------------- (Registrant) Date: May 9, 2006 by /s/ Michael C. Rechin -------------------------- ------------------------------------- Michael C. Rechin Executive Vice President and Chief Operating Officer (Principal Executive Officer) Date: May 9, 2006 by /s/ Mark K. Hardwick -------------------------- ------------------------------------- Mark K. Hardwick Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer) Page 30
FIRST MERCHANTS CORPORATION FORM 10-Q INDEX TO EXHIBITS INDEX TO EXHIBITS (a)3. Exhibits: Exhibit No.: Description of Exhibit: Form 10-Q Page No.: ------------ ------------------------- ------------------- 31.1 Certification of Chief 32 Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 31.2 Certification of Chief 33 Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 32 Certifications Pursuant to 34 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Page 31
EXHIBIT-31.1 FIRST MERCHANTS CORPORATION FORM 10-Q CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION - ------------- I, Michael C. Rechin, Executive Vice President and Chief Operating Officer of First Merchants Corporation, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of First Merchants Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report, based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board or directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: May 9, 2006 /s/Michael C. Rechin ---------------------------------------- Michael C. Rechin Executive Vice President and Chief Operating Officer (Principal Executive Officer) Page 32
EXHIBIT-31.2 FIRST MERCHANTS CORPORATION FORM 10-Q CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION - ------------- I, Mark K. Hardwick, Executive Vice President and Chief Financial Officer of First Merchants Corporation, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of First Merchants Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report, based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board or directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: May 9, 2006 /s/Mark K. Hardwick ---------------------------------------- Mark K. Hardwick Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer) Page 33
EXHIBIT-32 CERTIFICATIONS PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the quarterly report of First Merchants Corporation (the "Corporation") on Form 10-Q for the period ending March 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I Michael C. Rechin, Executive Vice President and Chief Operating Officer of the Corporation, do hereby certify, in accordance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o (d)); and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Date: May 9, 2006 by /s/ Michael C. Rechin --------------------------- ------------------------------------- Michael C. Rechin Executive Vice President and Chief Operating Officer (Principal Executive Officer) A signed copy of this written statement required by Section 906 has been provided to First Merchants Corporation and will be retained by First Merchants Corporation and furnished to the Securities and Exchange Commission or its staff upon request. In connection with the quarterly report of First Merchants Corporation (the "Corporation") on Form 10-Q for the period ending March 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I Mark K. Hardwick, Executive Vice President and Chief Financial Officer of the Corporation, do hereby certify, in accordance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o (d)); and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Date: May 9, 2006 by /s/ Mark K. Hardwick --------------------------- ------------------------------------- Mark K. Hardwick Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer) A signed copy of this written statement required by Section 906 has been provided to First Merchants Corporation and will be retained by First Merchants Corporation and furnished to the Securities and Exchange Commission or its staff upon request. Page 34