ChoiceOne Financial Services - 10-Q quarterly report FY

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q

CHOICEONE FINANCIAL SERVICES, INC.
INDEX TO FORM 10-Q

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements.

ChoiceOne Financial Services, Inc.

CONSOLIDATED BALANCE SHEETS

ChoiceOne Financial Services, Inc.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

ChoiceOne Financial Services, Inc.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

ChoiceOne Financial Services, Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

ChoiceOne Financial Services, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
The consolidated financial statements include ChoiceOne Financial Services, Inc. (the "Registrant") and its direct and indirect wholly owned subsidiaries, ChoiceOne Bank (the "Bank"), ChoiceOne Mortgage Company of Michigan (the "Mortgage Company"), and ChoiceOne Insurance Agencies, Inc. (the "Insurance Agency").

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information, prevailing practices within the banking industry and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

The accompanying consolidated financial statements reflect all adjustments ordinary in nature which are, in the opinion of management, necessary for a fair presentation of the Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004, the Consolidated Statements of Income for the three- and six-month periods ended June 30, 2005 and June 30, 2004, the Consolidated Statements of Changes in Shareholders' Equity for the six-month periods ended June 30, 2005 and June 30, 2004, and the Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2005 and June 30, 2004. Operating results for the six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 2004.

Stock-Based Compensation
Employee compensation expense under the Registrant's stock option plan is reported if options are granted below market price at the grant date. Pro forma disclosures of net income and earnings per share are shown using the fair value method to measure expense for options granted using an option pricing model to estimate the fair value.

The following pro forma information presents net income and earnings per share for the three- and six-month periods ended June 30, 2005 and 2004 had the fair value method been used to measure compensation expense for stock option plans. No compensation expense was recognized for stock options in 2005 and 2004.

Information regarding impaired loans follows:

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. (the "Registrant" or "ChoiceOne") and its direct and indirect wholly owned subsidiaries, ChoiceOne Bank (the "Bank"), ChoiceOne Insurance Agencies, Inc. (the "Insurance Agency") and ChoiceOne Mortgage Company of Michigan (the "Mortgage Company"). This discussion should be read in conjunction with the consolidated financial statements and related footnotes.

FORWARD-LOOKING STATEMENTS

This discussion and other sections of this report contain forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates, and projections about the financial services industry, the economy, and about the Registrant itself. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, the Registrant undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

Risk factors include, but are not limited to, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their ability to repay loans; and changes in the national and local economies. In addition, events relating to the current war on terrorism including the military action in Iraq have created significant global economic and political uncertainties that may have material and adverse effects on financial markets, the economy, and demand for financial services and products. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

RESULTS OF OPERATIONS

Summary
Net income increased $142,000 or 35% in the second quarter of 2005 compared to the same period in 2004. The increase for the quarter was primarily due to higher net interest income, higher noninterest income, and lower noninterest expense, partially offset by a higher provision to the allowance for loan losses.

Net income for the first six months of 2005 increased $145,000 or 16% from the same period in the prior year. The increase for the first six months was primarily due to higher net interest income and lower noninterest expense, partially offset by lower noninterest income and a higher provision to the allowance for loan losses. Net interest income increased in the first six months of 2005 compared to 2004 due to growth in the Bank's earning assets, which more than offset a drop in net interest spread. A higher provision to the allowance for loan losses was necessary due to commercial loan growth and higher consumer loan and residential real estate loan net charge-offs in the first six months of 2005 versus the same period in 2004. Noninterest income dipped slightly in the first six months of 2005 compared to the first six months of 2004 due to lower insurance and investment commissions. Noninterest expense for the first six months of 2005 has dropped compared to the same period of 2004 primarily due to an adjustment to Michigan single business tax expense and the effect of a $75,000 fraudulent check in 2004, offset by higher personnel and occupancy costs.

Return on average assets and return on average shareholders' equity was 0.92% and 10.30%, respectively, for the second quarter of 2005, compared to 0.73% and 7.86%, respectively, for the second quarter of 2004. Return on average assets was 0.91% for the first six months of 2005, compared to 0.84% for the same period in 2004. Return on average shareholders' equity was 10.03% for the first half of 2005, compared to 8.88% for the comparable period of 2004.

Dividends
Cash dividends of $278,000, or $0.17 per share were declared in the second quarter of 2005, compared to $267,000 or $0.16 per

share in the second quarter of 2004. The cash dividends declared in the first six months of 2005 were $545,000 or $0.33 per share, compared to $532,000 or $0.32 per share declared in 2004. The cash dividend payout percentage was 51% for the first six months of 2005, compared to 58% in the same period a year ago.

On April 20, 2005, the Registrant's Board of Directors declared a 5% stock dividend payable on the Registrant's common stock. The dividend was paid May 31, 2005 to shareholders of record as of May 9, 2005. Earnings per share data and outstanding shares of common stock for all periods presented have been adjusted for this stock dividend.

Interest Income and Expense
Tables 1 and 2 on the following pages provide information regarding interest income and expense for the six-month periods ended June 30, 2005 and 2004, respectively. Table 1 documents the average balances and related interest income and expense, as well as the average rates earned or paid on assets and liabilities. Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. These tables are referred to in the discussion of interest income, interest expense and net interest income below.

Table 1 - Average Balances and Tax-Equivalent Interest Rates

Table 2 - Changes in Tax-Equivalent Net Interest Income (Dollars in Thousands)

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3.46% for the twelve months ended December 31, 2004. The average yield received on interest-earning assets was up 20 basis points to 5.87% at June 30, 2005, and the average rate paid on interest-bearing liabilities was up 26 basis points to 2.45% at June 30, 2005.

Net interest income for the three months ended June 30, 2005 was $139,000 higher than net interest income for the quarter ended June 30, 2004 due to a higher average balance in earning assets and a slightly higher net interest income spread. Earning assets for the second quarter of 2005 were 7% higher than the second quarter of 2004. The net interest spread was 3.39% for the three months ended June 30, 2005 versus 3.38% for the quarter ended June 30, 2004.

Provision and Allowance for Loan Losses
The provision for loan losses was $70,000 higher for the quarter ended June 30, 2005 and $90,000 higher in the first six months of 2005 than 2004. The increase was driven by more growth in commercial loans as well as higher net charge-offs of consumer, commercial real estate, and residential real estate loans in 2005 than in 2004. Also, a significant portion of the commercial loan charge-offs experienced in the first six months of 2004 were specifically reserved for loss at the end of 2003, thereby causing the provision for 2004 to be lower relative to the provision for 2005. The allowance for loan losses has increased $74,000 since the end of 2004 primarily due to recoveries and the current year's provision. The allowance was 1.01% of total loans as of June 30, 2005, compared to 1.00% at March 31, 2005 and December 31, 2004. Charge-offs and recoveries of charged-off loans for the six months ended June 30 were as follows:

The Bank moved its Alpine Office from a leased location on Alpine Avenue in Comstock Park to a newly constructed office in July 2005. Management anticipates that occupancy expense may drop slightly in third and fourth quarters of 2005 as depreciation of the new branch is less than the depreciation of improvements to the former leased location.

FINANCIAL CONDITION

Securities
The securities portfolio decreased $3.2 million from December 31, 2004 to June 30, 2005. The majority of the decrease relates to corporate and municipal bonds that were sold in 2005 to fund the purchase of $2 million in bank-owned life insurance (BOLI) policies on certain officers of the Bank and Insurance Agency. Management believes BOLI is good financial alternative to help offset liabilities associated with its employee compensation and benefit programs. The income from BOLI is tax-exempt and is reported as an increase in the cash value of life insurance policies and is reflected in ChoiceOne's other noninterest income.

The Bank's Investment Committee continues to monitor the portfolio and purchase or sell securities when deemed prudent. Certain securities are also sold under agreements to repurchase and management plans to continue this practice as a low-cost source of funding. Certain securities are also pledged as collateral to the Federal Home Loan Bank for current and potential borrowings. Securities also serve as a source of liquidity for funding loan demand.

Loans
The loan portfolio (excluding loans held for sale) grew $6.0 million during the first six months of 2005. Commercial/industrial and commercial real estate loans supplied the bulk of the increase since year-end 2004. Higher demand from local businesses more than offset payoffs and regular payments. Residential real estate loans have remained essentially flat since year-end 2004. Approximately 30% or $5.1 million of conforming residential real estate loans were sold to investors in the first six months of 2005. Home equity loans have risen in the first six months of 2005 since year-end 2004 primarily due to debt consolidation by borrowers. Management's ability to continue to grow consumer loans may be affected by its decision in first quarter of 2005 to discontinue the origination of indirect automobile and other recreational vehicle loans. Indirect consumer loans totaled approximately $5.3 million at June 30, 2005.

Information regarding impaired loans can be found in Note 2 to the consolidated financial statements included in this report. In addition to its review of the loan portfolio for impaired loans, management also monitors the various nonperforming loans. Nonperforming loans are comprised of: (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or loans past due 90 days or more, which are considered troubled debt restructurings.

The balances of these nonperforming loans were as follows:

Deposits and Other Funding Sources
Total deposits have increased approximately $2.6 million since December 31, 2004. Noninterest-bearing demand deposits comprised $2.4 million or 94% of the increase. Management attributes the growth to promotion of its Ultimate Choice checking account and its customer referral program. Interest-bearing demand deposits have dropped $4.3 million due to some customers moving from checking accounts to certificates of deposit. Since year-end 2004, local certificates of deposit have grown $6.4 million due to the success of certain promotional rates and an influx of investment from local government entities. Local certificates have replaced the $1.0 million decline in brokered certificates since year-end 2004. Advances from the Federal Home Loan Bank increased by $3.0 million since year-end 2004 to fund new loan growth. Federal funds purchased increased approximately $0.6 million since the end of 2004, while repurchase agreements dropped approximately $0.4 million since December 31, 2004.

Shareholders' Equity
Total shareholders' equity increased $392,000 since December 31, 2004. The increase is largely attributable to the current year's income. Proceeds from the sale of ChoiceOne's stock offset most of the amount repurchased. Cash dividends declared and a change in the accumulated other comprehensive income mitigated some of the increase in total shareholder's equity. The stock dividend declared in 2005 had no impact on shareholder's equity. Total shareholders' equity as a percentage of assets was 9.01% as of June 30, 2005, compared to 9.07% as of December 31, 2004. The decrease in this ratio resulted from growth in assets outpacing growth in shareholders' equity during 2005. Based on risk-based capital guidelines established by the Registrant's regulators, the Registrant's risk-based capital was categorized as "well capitalized" at June 30, 2005.

Capital Resources
Management believes that the current level of capital is adequate to take advantage of potential opportunities that may arise for the Registrant or the Bank.

Liquidity and Rate Sensitivity
Management believes that the current level of liquidity is sufficient to meet the Bank's normal operating needs. This belief is based upon the availability of deposit growth from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds which can be purchased from correspondent banks, and advances available from the Federal Home Loan Bank. The Bank also has a secured line of credit available from the Federal Reserve Bank. The Bank does not anticipate that the secured line of credit will be used for normal operating needs, but could be used for liquidity purposes in special circumstances.

The Bank's sensitivity to interest rate changes is monitored by the Asset & Liability Management Committee (the "Committee"). The Committee uses a simulation model to subject rate-sensitive assets and liabilities to interest rate shocks. Assets and liabilities are subjected to an immediate rate shock and the effect on net income and shareholders' equity is measured. The rate shock computation as of June 30, 2005 caused net income to increase 2% if rates increased 200 basis points and decrease 7% if rates decreased 200 basis points. The market value of shareholders' equity will decrease 16% if rates immediately rose 200 basis points and increase 4% if rates immediately dropped 200 basis points. The Committee continues to monitor the effect of changes in interest rates upon the Registrant's financial condition.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

The information concerning quantitative and qualitative disclosures about market risk contained under the caption "Liquidity and Interest Rate Risk" on pages 12 through 14 of the Registrant's Annual Report to Shareholders for the year ended December 31, 2004 is here incorporated by reference. Such Annual Report was previously filed as Exhibit 13 to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004.

The Registrant's management does not believe that there has been a material change in the nature or categories of the Registrant's primary market risk exposures, or the particular markets that present the primary risk of loss to the Registrant. As of the date of this report, the Registrant's management does not know of or expect there to be any material change in the general nature of its primary market risk exposure in the near term. The methods by which the Registrant manages its primary market risk exposures, as described in the sections of its Annual Report to Shareholders incorporated by reference in response to this item, have not changed materially since the end of 2004. As of the date of this report, the Registrant's management does not expect to make material changes in those methods in the near term. The Registrant may change those methods in the future to adapt to changes in circumstances or to implement new techniques.

The Registrant's market risk exposure is mainly comprised of its vulnerability to interest rate risk. Prevailing interest rates and interest rate relationships are primarily determined by market factors that are beyond the Registrant's control. All information

provided in response to this item consists of forward-looking statements. Reference is made to the section captioned "Forward-Looking Statements" in Item 2 of this report for a discussion of the limitations on the Registrant's responsibility for such statements. In this discussion, "near term" means a period of one year following the date of the most recent balance sheet contained in this report.

Item 4.  Controls and Procedures.

An evaluation was performed under the supervision and with the participation of the Registrant's management, including the Chief Executive Officer and principal financial officer, of the effectiveness of the design and operation of the Registrant's disclosure controls and procedures. Based on and as of the time of that evaluation, the Registrant's management, including the Chief Executive Officer and principal financial officer, concluded that the Registrant's disclosure controls and procedures were effective as of the end of the period covered by this report. There was no change in the Registrant's internal control over financial reporting that occurred during the three months ended June 30, 2005 that has materially affected, or that is reasonably likely to materially affect, the Registrant's internal control over financial reporting.

PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings.

None.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

On April 20, 2005, the Registrant issued 782 shares of common stock to the directors of the Registrant pursuant to the Directors' Stock Purchase Plan for an aggregate cash price of $17,000. The Registrant relied on the exemption contained in Section 4(6) of the Securities Act of 1933 in connection with this sale.

ISSUER PURCHASES OF EQUITY SECURITIES

Item 4.  Submission of Matters to a Vote of Security Holders.

On April 28, 2005, the Annual Meeting of Shareholders of the Registrant was held. The following directors were elected by the shareholders to serve until the 2008 Annual Meeting:

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.

INDEX TO EXHIBITS

The following exhibits are filed or incorporated by reference as part of this report: