UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington D.C. 20549FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.For the fiscal year ended December 31, 2002
Commission File Number: 000-49733
FIRST INTERSTATE BANCSYSTEM, INC.(Exact name of registrant as specified in its charter)
(406) 255-5390(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common stockwithout par value per share
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. [ ü ] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ] Yes [ü] No
The aggregate market value (appraised minority value) of the common stock of the registrant held by non-affiliates as of the last business day of the registrant's most recently completed second fiscal quarter, June 30, 2002, was $13,769,624.
The number of shares outstanding of the registrant’s common stock as of February 28, 2003 was 7,878,977.
Documents Incorporated by Reference
The registrant intends to file a definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held May 9, 2003. The information required by Part III of this Form 10-K is incorporated by reference from such Proxy Statement.
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TABLE OF CONTENTS
PART I
Item 1. Business
The Company
First Interstate BancSystem, Inc. (“FIBS” and collectively with its subsidiaries, the “Company”), incorporated in Montana in 1971, is a financial holding company registered under the Bank Holding Company Act of 1956, as amended. FIBS is headquartered in Billings, Montana. As of December 31, 2002, the Company had assets of $3.6 billion, deposits of $2.9 billion and total stockholders’ equity of $244 million, making it the largest banking organization in Montana.
FIBS operates a wholly-owned bank subsidiary, First Interstate Bank (the “Bank”), with 57 banking offices in 30 Montana and Wyoming communities. The Bank, a Montana corporation organized in 1916, delivers a comprehensive range of loan, deposit and investment products and mortgage banking and trust services to meet the needs of individual customers, businesses, and municipalities.
The Company conducts various other financial-related business activities through wholly-owned non-bank subsidiaries. i_Tech Corporation (“i_Tech”) provides technology services to the Bank and other non-affiliated customers in Montana, Wyoming, Idaho, Washington, Oregon, South Dakota and Colorado. Additionally, i_Tech’s ATM network provides processing support for over 2,093 ATM locations in 32 states. FIB Capital Trust (“FIB Capital”), incorporated under Delaware law in 1997, was formed for the exclusive purpose of issuing mandatorily redeemable trust preferred securities (“trust preferred securities”) and using the proceeds to purchase junior subordinated debentures (“subordinated debentures”) issued by FIBS. FI Reinsurance, Ltd. (“FIR”), domiciled in Nevis Island, West Indies, was formed in 2001 to underwrite, as reinsurer, credit-related life and disability insurance.
The Company is the licensee under a trademark license agreement granting it an exclusive, nontransferable license to use the “First Interstate” name and logo in Montana, Wyoming and surrounding states.
Community Banking Philosophy
The banking industry continues to experience change with respect to regulatory matters, consolidation, consumer needs and economic and market conditions. The Company believes that it can best address this changing environment through its “Strategic Vision.” The Company’s Strategic Vision emphasizes providing its customers full service commercial and consumer banking at a local level using a personalized service approach, while serving and strengthening the communities in which the Bank is located through community service activities.
The Company grants significant autonomy to its banking offices in delivering and pricing products at a local level in response to market considerations and customer needs. This autonomy enables the banking offices to remain competitive and enhances the relationships between the banking offices and the customers they serve. The Company also emphasizes accountability, however, by establishing performance and incentive standards that are tied to net income and other success measures at the individual banking office and market level. The Company believes this combination of autonomy and accountability allows the banking offices to provide personalized customer service while remaining attentive to financial performance.
The Company has centralized certain products and business activities to provide consistent service levels to customers Company-wide, to gain efficiency in management of those products and activities and to ensure regulatory compliance. Centralized products and activities include trust, investment, wire transfer, escrow, credit card, technology and escrow services; mortgage servicing; and selected operational activities.
Growth Strategy
The Company’s growth strategy includes growing internally and expanding into new and complementary markets when appropriate opportunities arise. The Company believes it has an infrastructure in place that will allow for growth and provide economies of scale into the future.
The Company has opened 19 new banking offices in Montana and Wyoming since 1999. Among these new offices are 11 full service banking offices located inside retail establishments. The Company intends to continue to expand its presence in the Montana and Wyoming markets through the opening of new banking offices; however, future growth through de novo banking offices is likely to occur at a slower rate than the Company has experienced during the previous three years.
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In January 2003, the Company acquired Silver Run Bancorporation, Inc. (“SRBI”), a bank holding company with one banking office. At the date of acquisition, SRBI had loans of $36 million and deposits of $42 million.
The Bank
The Company’s banking offices are located in communities of approximately 700 to 90,000 people, but serve larger market areas due to the limited number of financial institutions in other nearby communities. The Company believes that the communities served provide a stable core deposit and funding base, as well as economic diversification across a number of industries, including agriculture, energy, mining, timber processing, tourism, government services, education and medical services.
Centralized Services
FIBS and i_Tech provide general oversight and centralized services for the Bank to enable it to serve its markets more effectively. These services include technology services, credit administration, finance and accounting, human asset management and other support services.
Technology Services. i_Tech provides technology services to the Bank, including system support of the general ledger, investment security, loan, deposit, web banking, imaging, management reporting and cash management systems. i_Tech also manages the Company’s wide-area network and the ATM network used by the Bank and provides item proof and capture services. These technology services are performed through the use of computer hardware owned and maintained by the Bank and software licensed by i_Tech.
Credit Administration. FIBS assists the Bank in identifying, measuring and monitoring loan concentrations, problem loans and loan portfolio trends. FIBS also controls the risk inherent in the Bank’s loan portfolio through training of Bank personnel; evaluating and implementing periodic modifications to the Bank’s loan policy and lending limits; and, assisting the Bank in determining the loan loss reserve including specific reserve allocations.
Finance and Accounting. FIBS provides financial and accounting services for the Bank, including internal and external reporting, asset/liability management, investment portfolio analysis and capital management.
Human Asset Management. Through its human asset management group, FIBS provides the Bank with incentive and employee benefit administration and compensation, training, employee recruitment and hiring services.
Other Support Services. FIBS provides the Bank with legal, compliance, internal auditing, general administration and various other support services.
Lending Activities
FIBS has comprehensive credit policies establishing Company-wide underwriting and documentation standards to assist Bank management in the lending process and limit risk to the Company. The credit policies establish lending authorities based on the experience level and authority of the lending officer, the type of loan and the type of collateral. The policies also establish thresholds at which loan requests must be approved by a Bank committee.
The Bank offers short and long-term real estate, consumer, commercial, agricultural and other loans to individuals and small to medium-sized businesses in its market areas. While each loan must meet minimum underwriting standards established in the Company’s credit policies, lending officers are granted certain levels of autonomy in approving and pricing loans to assure that the banking offices are responsive to competitive issues and community needs in each market area.
Real Estate Loans. The Bank provides interim and permanent financing for both single-family and multi-unit properties, medium-term loans for commercial, agricultural and industrial property and/or buildings and equity lines of credit secured by real estate. The Bank originates variable and fixed rate real estate mortgages, generally in accordance with the guidelines of Fannie Mae and Federal Home Loan Mortgage Corporation. Loans originated in accordance with these guidelines are sold in the secondary market. Real estate loans not sold in the secondary market are typically secured by first liens on the financed property and generally mature in less than 15 years.
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Consumer Loans. The Bank’s consumer loans include personal loans, credit card loans and equity lines of credit. Personal loans are generally secured by automobiles, boats and other types of personal property and are made on an installment basis. Credit cards are offered to customers in the Company’s market areas. Equity lines of credit are generally floating rate, reviewed annually and secured by real property. Approximately 55% of the Company’s consumer loans are indirect dealer paper that is created when the Company purchases consumer loan contracts advanced for the purchase of automobiles, boats and other consumer goods from consumer product dealers.
Commercial Loans. The Bank provides a mix of variable and fixed rate commercial loans. The loans are typically made to small and medium-sized manufacturing, wholesale, retail and service businesses for working capital needs and business expansions. Commercial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with business operations as the primary source of repayment, but also include collateralization by inventory, accounts receivable, equipment and/or personal guarantees.
Agricultural Loans. The Bank’s agricultural loans generally consist of short and medium-term loans and lines of credit that are generally used for crops, livestock, equipment and general operating purposes. Agricultural loans are generally secured by assets such as livestock or equipment and are repaid from the operations of the farm or ranch. Agricultural loans generally have maturities of five years or less, with operating lines for one production season.
For additional information about the Company’s loan portfolio, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Loans.”
Funding Sources
The Bank offers traditional depository products including checking, savings and time deposits. Additional funding sources include Federal funds purchased for one day periods, repurchase agreements with primarily commercial depositors, time deposits brokered outside the Company’s market areas and short-term borrowings from the Federal Home Loan Bank of Seattle. Deposits at the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to statutory limits.
Under repurchase agreements, the Company sells investment securities held by the Company to a customer under an agreement to repurchase the investment security at a specified time or on demand. The Company does not, however, physically transfer the investment securities. As of December 31, 2002, all outstanding repurchase agreements were due in one day.
For additional information on the Banks’ funding sources, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Deposits,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Other Borrowed Funds,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Federal Funds Purchased and Securities Sold Under Repurchase Agreements,” included in Part II, Item 7.
Competition
Competition within Montana and Wyoming for banking and related business is strong. The Bank competes with both state and nationally chartered commercial banks for deposits, loans and trust accounts and with savings and loan associations, savings banks and credit unions for deposits and loans. In addition, there is significant competition with other institutions including personal loan companies, mortgage banking companies, finance companies, insurance companies, securities firms, mutual funds and certain government agencies as well as major retailers, all actively engaged in providing various types of loans and other financial services.
While historically the technology services industry has been highly decentralized, there is an accelerating trend toward consolidation resulting in fewer companies competing over larger geographic regions. i_Tech’s competitors vary in size and include national, regional and local operations.
Employees
At December 31, 2002, the Company employed 1,605 full-time equivalent employees. None of the Company’s employees are covered by a collective bargaining agreement. The Company considers its employee relations to be good.
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Regulation and Supervision
Financial holding companies and commercial banks are subject to extensive regulation under both federal and state law. Set forth below is a summary description of certain laws that relate to the regulation of FIBS and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
First Interstate BancSystem, Inc.
As a bank holding company and financial holding company, FIBS is subject to regulation under the Bank Holding Company Act of 1956, as amended, and to supervision and regulation by the Federal Reserve.
Under Federal Reserve regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both.
FIBS is required to obtain the prior approval of the Federal Reserve for the acquisition of 5% or more of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve is also required for the merger or consolidation of FIBS and another bank holding company.
As a financial holding company, FIBS may engage in certain business activities that are determined by the Federal Reserve to be financial in nature or incidental to financial activities as well as all activities authorized to bank holding companies. FIBS may engage in authorized financial activities provided that it remains a financial holding company and meets certain regulatory standards of being well-capitalized and well-managed. FIBS must notify the Federal Reserve of its financial activities within a specified time period following its initial engagement in each business or activity.
The Bank is subject to the supervision of and regular examination by the Federal Reserve, the State of Montana, Division of Banking and Financial Institutions and, with respect to its activities in Wyoming, the State of Wyoming, Department of Audit. If any of the foregoing regulatory agencies determines that the financial condition, capital resources, asset quality, earning prospects, management, liquidity or other aspects of a bank’s operations are unsatisfactory or that a bank or its management is violating or has violated any law or regulation, various remedies are available to such agencies. These remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of a bank, to assess civil monetary penalties, to remove officers and directors and to terminate a bank’s deposit insurance, which would result in a revocation of a bank’s charter. The Bank has not been the subject of any such actions by regulatory agencies.
The FDIC insures the deposits of the Bank in the manner and to the extent provided by law. For this protection, the Bank pays a semiannual statutory assessment. See “Premiums for Deposit Insurance” herein.
Restrictions on Transfers of Funds to FIBS and the Bank
Large portions of FIBS’s revenues are, and will continue to be, dividends paid by the Bank. The Bank is limited, under both state and federal law, in the amount of dividends that may be paid from time to time. In general, the Bank is limited, without the prior consent of its state and federal banking regulators, to paying dividends that do not exceed the current year net profits together with retained earnings from the two preceding calendar years.
A state or federal banking regulator may impose, by regulatory order or agreement of the Bank, specific regulatory dividend limitations or prohibitions in certain circumstances. The Bank is not subject to a specific regulatory dividend limitation other than generally applicable limitations. In addition to regulatory dividend limitations, the Bank dividends are, in certain circumstances, limited by covenants in FIBS’s debt instruments.
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Financial and other transactions between the Bank and FIBS or any FIBS affiliate are also limited under applicable state and federal law. Among other things, the Bank may not lend funds to, or otherwise extend credit to or for the benefit of, FIBS or FIBS affiliates, except on specified types and amounts of collateral and other terms required by state and federal law. In addition, the Federal Reserve has authority to define and limit, from time to time, the transactions between banks and their affiliates. The Federal Reserve has issued Regulation W, to be effective April 1, 2003. Regulation W imposes significant additional limitations on transactions in which the Bank may engage with FIBS or FIBS affiliates in addition to the limits under the federal statutes.
Effect of Government Policies and Legislation
Banking depends on interest rate differentials. In general, the difference between the interest rate paid by the Bank on deposits and borrowings and the interest rate received by the Bank on loans extended to customers and on investment securities comprises a major portion of the Bank’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and potential growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve. The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States government securities, by adjusting the required level of reserves for financial institutions subject to the Federal Reserve’s reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial service providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial service providers are frequently made in Congress, in the Montana and Wyoming legislatures and before various bank regulatory and other professional agencies. The likelihood of major legislative changes and the impact such changes might have on FIBS or the Bank are impossible to predict.
Capital Standards
The federal banking agencies have adopted minimum capital requirements for insured banks that are applicable to the Bank. In addition, the Federal Reserve has adopted minimum capital requirements that are applicable to FIBS. The capital requirements are intended to, among other things, provide a means for evaluating the capital adequacy and soundness of the institutions. The Federal banking agencies may also set higher capital requirements for particular institutions in specified circumstances under Federal laws and regulations.
At December 31, 2002, the Bank and FIBS each met the “well-capitalized” requirements applicable to the respective institution. The “well-capitalized” standard is the highest level of the minimum capital requirements established by the Federal agencies. Neither the Bank nor FIBS is subject to a minimum capital requirement other than those applicable to banks or bank holding companies generally.
For more information concerning the capital ratios of FIBS, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital Resources” and “Notes to Consolidated Financial Statements – Regulatory Capital” included in Part IV, Item 15.
Compliance and Safety and Soundness Standards
The federal banking agencies have adopted guidelines establishing standards for safety and soundness, asset quality, and earnings, as required by the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”). These standards are designed to identify potential concerns and ensure that action is taken to address those concerns before they pose a risk to the deposit insurance fund. If a federal banking agency determines that an institution fails to meet any of these standards, the agency may require the institution to submit an acceptable plan to achieve compliance with the standard. If the institution fails to submit an acceptable plan within the time allowed by the agency or fails in any material respect to implement an accepted plan, the agency must, by order, require the institution to correct the deficiency.
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Premiums for Deposit Insurance
Deposits in the Bank are insured by the FDIC in accordance with the Federal Deposit Insurance Act (the “FDIA”). Insurance premiums are assessed semiannually by the FDIC at a level sufficient to maintain the insurance reserves required under the FDIA and relevant regulations. The insurance premium charged to a bank is determined based upon risk assessment criteria, including relevant capital levels, results of bank examinations by state and federal regulators and other information. The Bank currently is assessed the most favorable deposit insurance premiums under the risk-based premium system.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities or in authorizing expansion activities by the Bank and FIBS.
In connection with its assessment of CRA performance, the appropriate bank regulatory agency assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank received an “outstanding” rating on its most recent examination.
Risk Factors
Asset Quality
A significant source of risk for the Company arises from the possibility that losses will be sustained by the Bank because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that management believes are appropriate to mitigate this risk by assessing the likelihood of nonperformance, monitoring loan performance and diversifying the Company’s credit portfolio. Such policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Company’s business, financial condition and results of operations. See “Business – Lending Activities.”
Interest Rate Risk
Banking companies’ earnings depend largely on the relationship between the yield on earning assets, primarily loans and investments, and the cost of funds, primarily deposits and borrowings. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest earning assets and interest bearing liabilities, and the level of non-performing assets. Fluctuations in interest rates affect the demand of customers for the Company’s products and services. The Company is subject to interest rate risk to the degree that its interest bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than its interest earning assets. Significant fluctuations in interest rates could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
For additional information regarding interest rate risk, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Liquidity and Cash Flow.”
Economic Conditions; Limited Geographic Diversification
The Company’s banking operations are located in Montana and Wyoming. As a result of the geographic concentration of its operations, the Company’s results depend largely upon economic conditions in these areas. Although markets served by the Company are economically diverse, a deterioration in economic conditions could adversely impact the quality of the Company’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
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Ability of the Company to Execute Its Business Strategy
The financial performance and profitability of the Company will depend on its ability to execute its business strategy and manage its future growth. Although the Company believes that it has substantially integrated recently acquired banks into the Company’s operations, there can be no assurance that unforeseen issues relating to the assimilation or prior operations of these banks, including the emergence of any material undisclosed liabilities, will not materially adversely affect the Company. In addition, any future acquisitions or other future growth may present operating and other problems that could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. The Company’s financial performance will also depend on the Company’s ability to maintain profitable operations through implementation of its Strategic Vision. Moreover, the Company’s future performance is subject to a number of factors beyond its control, including pending and future federal and state banking legislation, regulatory changes, unforeseen litigation outcomes, inflation, lending and deposit rate changes, interest rate fluctuations, increased competition and economic conditions. Accordingly, there can be no assurance that the Company will be able to continue the growth or maintain the level of profitability it has recently experienced.
Dependence on Key Personnel
The Company’s success depends to a significant extent on the management skills of its existing executive officers and directors, many of whom have held officer and director positions with the Company for many years. The loss or unavailability of any of its key executives, including Thomas W. Scott, Chief Executive Officer, Lyle R. Knight, President and Chief Operating Officer, Terrill R. Moore, Senior Vice President and Chief Financial Officer, or Ed Garding, Senior Vice President and Chief Credit Officer could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See Part III, Item 10, “Directors and Executive Officers of Registrant.” In December 2002, the Company announced the beginning of a year-long management transition process. Effective January 1, 2004, Thomas W. Scott will assume the role of Chairman of the Board of Directors of the Company. Lyle R. Knight will succeed Mr. Scott as Chief Executive Officer. Mr. Scott will remain active in oversight of the Company.
Several competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. Moreover, the Riegal-Neal Interstate Banking and Branching Efficiency Act of 1994 has increased competition in the Bank’s markets, particularly from larger, multi-state banks. There can be no assurance that the Company will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business – Competition” and “Business – Regulation and Supervision.”
Government Regulation and Monetary Policy
The Company and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Company conducts its banking business, undertakes new investments and activities and obtains financing. This regulation is designed primarily for the protection of the deposit insurance funds and consumers and not to benefit holders of the Company’s securities. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Company. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company, and any unfavorable change in these conditions could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business-Regulation and Supervision.”
Control by Affiliates
The directors and executive officers of the Company beneficially own 51.9% of the outstanding common stock of the Company. Many of these directors and executive officers are members of the Scott family, which collectively owns 80.3% of the outstanding common stock. By virtue of such ownership, these affiliates are able to control the election of directors and the determination of the Company’s business, including transactions involving any merger, share exchange, sale of assets outside the ordinary course of business and dissolution.
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Lack of Trading Market; Market Prices
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 91.6% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 8.4% without such restrictions. FIBS has the right of first refusal to repurchase the restricted stock at fair market value per share currently determined as the minority appraised value per share based upon the most recent quarterly appraisal available to FIBS. Additionally, restricted stock held by officers, directors and employees of the Company may be called by the Company under certain conditions. All stock not subject to such restrictions may be sold at a price per share that is acceptable to the shareholder. FIBS has no obligation to purchase unrestricted stock, but has historically purchased such stock. During 2002, the Company repurchased 22,953 shares of its unrestricted stock from participants in the Savings and Profit Sharing Plan for Employees of First Interstate BancSystem, Inc. (“Savings Plan”) and 55,107 shares of its restricted stock from shareholders. All shares were repurchased at the most recent minority appraised value at the repurchase date.
The appraised minority value of the FIBS common stock represents the estimated fair market valuation of a minority block of such stock, taking into account adjustments for the lack of marketability of the stock and other factors. This value does not represent an actual trading price between a willing buyer and seller of the FIBS common stock in an informed, arm’s-length transaction. As such, the appraised minority value is only an estimate as of a specific date, and there can be no assurance that such appraisal is an indication of the actual value holders of FIBS common stock may realize with respect to shares held by them. Moreover, the estimated fair market value of the FIBS common stock may be materially different at any date other than the valuation dates.
With limited exceptions, FIBS has no obligation, by contract, policy or otherwise to purchase stock from any shareholder desiring to sell or to create any market for the stock. Historically, it has been the practice of FIBS to repurchase common stock to maintain a shareholder base with restrictions on sale or transfer of the stock. In the last three calendar years (2000-2002), FIBS has repurchased a total of 342,618 shares of common stock, 254,706 of which were restricted by shareholder agreements. FIBS repurchased the stock at the most recent appraised minority value at the repurchase date, in accordance with the shareholder agreements. FIBS’s repurchases of stock are subject to corporate law and regulatory restrictions that could prevent stock repurchases. See also Part II, Item 5, “Market for Registrant’s Common Equity and Related Stockholder Matters.”
There is a limited public market for the trust preferred securities. Future trading prices of the trust preferred securities depend on many factors including, among other things, prevailing interest rates, the operating results and financial condition of the Company and the market for similar securities. As a result of the existence of FIBS’s right to defer interest payments on or, subject to prior approval of the Federal Reserve if then required under applicable capital guidelines or policies of the Federal Reserve, shorten the stated maturity of the subordinated debentures, the market price of the trust preferred securities may be more volatile than the market prices of subordinated debentures that are not subject to such optional deferrals or reduction in maturity. There can be no assurance as to the market prices for the trust preferred securities or the subordinated debentures that may be distributed in exchange for the trust preferred securities if the Company exercises its right to dissolve FIB Capital.
Forward-Looking Statements
Certain statements contained in this document including, without limitation, statements containing the words “believes,” “anticipates,” “expects,” and words of similar import, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates; demographic changes; competition; fluctuations in interest rates; changes in business strategy or development plans; changes in governmental regulation; credit quality; the availability of capital to fund the expected expansion of the Company’s business; and, other factors referenced in this document, including, without limitation, information under the captions “Risk Factors” and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Given these uncertainties, shareholders, trust preferred security holders and prospective investors are cautioned not to place undue reliance on such forward-looking statements. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.
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Website Access to United States Securities and Exchange Commission Filings
All reports filed electronically by the Company with the United States Securities Exchange Commission (“SEC”), including the annual report on Form 10-K, quarterly reports on Form 10-Q and current event reports on Form 8-K, as well as amendments to those reports, are accessible at no cost through the Company’s website at firstinterstatebank.com. These filings are also accessible on the SEC’s website at www.sec.gov.
Item 2. Properties
The Company is the anchor tenant in a commercial building in which the Company’s principal executive offices are located in Billings, Montana. The building is owned by a joint venture partnership in which the Bank is one of the two partners, owning a 50% interest in the partnership. As of December 31, 2002, the Company leases approximately 68,879 square feet of space for operations in the building. The Company also leases space for operations, technology services and 24 banking offices in 31 buildings. All other banking offices are located in Company-owned facilities.
Item 3. Legal Proceedings
In the normal course of business, the Company is named or threatened to be named as a defendant in various lawsuits. In the opinion of management, following consultation with legal counsel, the pending lawsuits are without merit or, in the event the plaintiff prevails, the ultimate liability or disposition thereof will not have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Description of FIBS Capital Stock
The authorized capital stock of FIBS consists of 20,000,000 shares of common stock without par value, of which 7,799,748 shares were outstanding as of December 31, 2002, and 100,000 shares of preferred stock without par value, none of which were outstanding as of December 31, 2002.
Common Stock
Each share of the common stock is entitled to one vote in the election of directors and in all other matters submitted to a vote of shareholders. Accordingly, holders of a majority of the shares of common stock entitled to vote in any election of directors may elect all of the directors standing for election if they choose to do so, subject to the rights of the holders of the preferred stock. Voting for directors is noncumulative.
Subject to the preferential rights of any preferred stock that may at the time be outstanding, each share of common stock has an equal and ratable right to receive dividends when, if and as declared by the Board of Directors out of assets legally available therefore. In the event of a liquidation, dissolution or winding up of the Company, the holders of common stock will be entitled to share equally and ratably in the assets available for distribution after payments to creditors and to the holders of any preferred stock that may at the time be outstanding. Holders of common stock have no conversion rights or preemptive or other rights to subscribe for any additional shares of common stock or for other securities. All outstanding common stock is fully paid and non-assessable.
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 91.6% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 8.4% held by 16 shareholders without such restrictions, including the Company’s 401(k) plan which holds 76.8% of the unrestricted shares. See also Part I, Item 1, “Risk Factors – Lack of Trading Market; Market Prices.”
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Quarter-end minority appraisal values for the past two years, determined by Alex Sheshunoff & Co. Investment Banking are as follows:
As of December 31, 2002, options for 594,151 shares of the FIBS common stock were outstanding at various exercise prices, ranging from $12.40 to $45.00. The aggregate cash proceeds to be received by FIBS upon exercise of all options outstanding at December 31, 2002 would be $24.9 million, or a weighted average exercise price of $41.96 per share.
Resale of FIBS stock may be restricted pursuant to the Securities Act of 1933 and applicable state securities laws. In addition, most shares of FIBS stock are subject to shareholder’s agreements:
Purchases of FIBS common stock made through the Company’s Savings Plan are not restricted by Shareholder Agreements, due to requirements of Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code. However, since the Savings Plan does not allow distributions “in kind,” any distributions from an employee’s account in the Savings Plan will allow, and may require, the Trust Department of the Bank (the “Plan Trustee”), to sell the FIBS stock. While FIBS has no obligation to repurchase the stock, it is likely that FIBS will repurchase FIBS stock sold by the Savings Plan. Any such repurchases would be upon terms set by the Plan Trustee and accepted by FIBS.
There are 581 record shareholders of FIBS as of December 31, 2002, including the Company’s Savings Plan as trustee for 503,949 shares held on behalf of 876 individual participants in the plan. 257 individuals in the Savings Plan also own shares of FIBS stock outside of the Plan. The Plan Trustee votes the shares based on the instructions of each participant. In the event the participant does not provide the Plan Trustee with instructions, the Plan Trustee votes those shares in accordance with voting instructions received from a majority of the participants in the Plan.
Dividends
It is the policy of FIBS to pay a dividend to all common shareholders quarterly. Dividends are declared and paid in the month following the calendar quarter and the amount has historically been determined based upon a percentage of net income for the calendar quarter immediately preceding the dividend payment date. Since 1996, the Company has paid dividends of approximately 30% of quarterly net income without taking into effect compensation expense or benefit related to stock options. The Board of Directors of FIBS has no current intention to change its dividend policy, but no assurance can be given that the Board may not, in the future, change or eliminate the payment of dividends.
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Historical quarterly dividends for 2001 and 2002 are as follows:
Dividend Restrictions
For a description of restrictions on the payment of dividends, see “Regulation and Supervision – Restrictions on Transfers of Funds to FIBS and the Bank.”
Preferred Stock
The authorized capital stock of FIBS includes 100,000 shares of preferred stock. The FIBS Board of Directors is authorized, without approval of the holders of common stock, to provide for the issuance of preferred stock from time to time in one or more series in such number and with such designations, preferences, powers and other special rights as may be stated in the resolution or resolutions providing for such preferred stock. FIBS Board of Directors may cause FIBS to issue preferred stock with voting, conversion and other rights that could adversely affect the holders of the common stock or make it more difficult to effect a change of control of the Company.
Securities Authorized for Issuance Under Equity Compensation Plans
Information concerning “Securities Authorized for Issuance Under Equity Compensation Plans” is set forth under the heading “Director and Executive Compensation – Executive Compensation — Equity Compensation Plans” in the Company’s Proxy Statement and is herein incorporated by reference.
Sales of Unregistered Securities
During 2002, the Company issued 3,000 shares of its common stock to one of its former executive officers who exercised stock options. The weighted average exercise price of the options was $19.02 per share. The shares were immediately redeemed by the Company at the minority appraised value of $43.00 per share. During 2002, the Company issued 4,088 unregistered shares of its common stock to 60 senior officers valued at an aggregate of $171,696 as part of the incentive bonuses paid to them. These issuances were made in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933.
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Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data with respect to the Company’s consolidated financial position as of December 31, 2002 and 2001 and its results of operations for the fiscal years ended December 31, 2002, 2001 and 2000, has been derived from the consolidated financial statements of the Company included in Part IV, Item 15. This data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and such consolidated financial statements, including the notes thereto.
Five Year Summary(Dollars in thousands except share and per share data)
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Five Year Summary, continued(Dollars in thousands except share and per share data)
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion and analysis is intended to provide greater details of the results of operations and financial condition of the Company. The following discussion should be read in conjunction with the information under Part II, Item 6, “Selected Consolidated Financial Data” and the Company’s consolidated financial statements, including the notes thereto, and other financial data appearing elsewhere in this document. Certain statements included in the following discussion constitute “forward-looking statements” which involve various risks and uncertainties. The Company’s actual results may differ significantly from those anticipated in such forward-looking statements. Factors that might cause such a difference include, without limitation, the ability of the Company to execute its business strategy, interest rate risk, economic conditions, government regulation, competition and asset quality. For additional information concerning these and other factors, see Part I, Item 1, “Business — Risk Factors.”
Results of Operations
Increases in the Company’s earnings during recent years have been effected through a successful combination of acquisitions and internal growth. Internal growth experienced by the Company is reflected by an increased volume of customer loans and deposits, without giving effect to acquisitions. The Company’s internal growth has largely been accomplished through a combination of effective offering and promotion of competitively priced products and services and the opening of several de novo banking offices. Net income was $34.5 million, or $4.41 per diluted share, in 2002 as compared to $31.2 million, or $3.94 per diluted share, in 2001 and $30.4 million, or $3.78 per diluted share, in 2000.
Net Interest Income
Net interest income, the largest source of the Company’s operating income, is derived from interest, dividends and fees received on interest earning assets, less interest expense incurred on interest bearing liabilities. Interest earning assets primarily include loans and investment securities. Interest bearing liabilities include deposits and various forms of indebtedness.
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The following table presents, for the periods indicated, condensed average balance sheet information for the Company, together with interest income and yields earned on average interest earning assets and interest expense and rates paid on average interest bearing liabilities.
Average Balance Sheets, Yields and Rates
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Net interest income on a fully-taxable equivalent (“FTE”) basis increased 8.4% to $138.8 million in 2002 from $128.1 million in 2001 and 13.6% to $128.1 million in 2001 from $112.8 million in 2000 primarily due to strong growth in loans and deposits combined with increases in the spread between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. The net yield on interest earning assets remained stable at 4.66% in 2002 and 2001. A more favorable earning asset mix allowed the net yield on earning assets to increase 7 basis points to 4.66% in 2001 from 4.59% in 2000.
Customer loan fees, included in net interest income, increased 2.8% to $7.3 million in 2002 from $7.1 million in 2001 primarily due to a record number of mortgage loans originated in 2002, the result of historically low interest rates. All other major categories of loan fee income decreased in 2002 as compared to 2001. Customer loan fees increased 36.5% to $7.1 million in 2001 from $5.2 million in 2000 with the most significant increases occurring in commercial and consumer loan fees.
The most significant impact on the Company’s net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest earning assets and interest bearing liabilities. The volume of loans, investment securities and other interest earning assets, compared to the volume of interest bearing deposits and indebtedness, combined with the interest rate spread, produces changes in the net interest income between periods.
The table below sets forth, for the periods indicated, a summary of the changes in interest income and interest expense resulting from estimated changes in average asset and liability balances (volume) and estimated changes in average interest rates (rate). Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percent changes in average volume and average rate as they compare to each other.
Analysis of Interest Changes Due To Volume and Rates(Dollars in thousands)
Provision for Loan Losses
The provision for loan losses creates an allowance for loan losses known and inherent in the loan portfolio at each balance sheet date. The Company performs a quarterly assessment of the risks inherent in its loan portfolio, as well as a detailed review of each significant asset with identified weaknesses. Based on this analysis, the Company records a
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provision for loan losses in order to maintain the allowance for loan losses at assessed levels. Periodically, provisions are made for loans where the probable loss can be individually identified and reasonably determined, while the balance of the provisions for loan losses are based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. Fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses. Ultimate loan losses may vary from current estimates. For additional information concerning the provision for loan losses, see “Critical Accounting Policies” herein.
The provision for loan losses increased 17.2% to $9.2 million in 2002 from $7.8 million in 2001 and 48.5% to $7.8 million in 2001 from $5.3 million in 2000. Increases in the provisions for loan losses are primarily due to increases in problem loans, softening economic conditions in the Company’s market areas, particularly in the agriculture and hotel/motel market sectors, and slowing regional and national economies.
Noninterest Income
The principal sources of noninterest income include service charges on deposit accounts; technology services revenues; other service charges, commissions and fees; and, income from fiduciary activities, comprised principally of fees earned on trust assets. Noninterest income increased 16.8% to $60.9 million in 2002 from $52.1 million in 2001 and 18.1% to $52.1 million in 2001 from $44.2 million in 2000. Increases in noninterest income are a function of changes in each of the principal categories, as discussed below.
Services charges on deposit accounts increased 7.6% to $15.7 million in 2002 from $14.6 million in 2001 primarily due to increases in business checking account fees. Service charges on deposit accounts increased 16.2% to $14.6 million in 2001 from $12.6 million in 2000 primarily due to new banking offices opened or acquired since June 2000 and increases in volume of overdraft fees charged.
Technology services revenues increased 7.7% to $11.0 million in 2002 from $10.2 million in 2001 primarily due to additional products provided to existing core data and item processing customers, the implementation of new item processing pricing schedules and higher ATM transaction volumes. Technology services revenues of $10.2 million in 2001 were flat as compared to 2000. During 2001, increases in core data processing revenues were largely offset by decreases in item processing revenues.
Other service charges, commissions and fees primarily include origination and processing fees on real estate loans held for sale, mortgage servicing fee income, credit card fees, brokerage revenues, debit card interchange fees and ATM service charge revenues. Other service charges, commissions and fees increased 25.7% to $21.1 million in 2002 from $16.8 million in 2001 and 44.7% to $16.8 million in 2001 from $11.6 million in 2000. Origination and processing fees on real estate loans sold in the secondary market increased $2.7 million in 2002 as compared to 2001 and $4.0 million in 2001 as compared to 2000 principally due to a Company-wide emphasis on growth in residential real estate loan origination combined with increased refinancing activity, the result of declining residential lending rates. The remaining increases in 2002 and 2001 are primarily attributable to mortgage servicing fee income generated through internal growth and the acquisition of mortgage servicing rights and increases in debit card interchange fees resulting from higher transaction volumes.
Revenues from fiduciary activities are largely dependent on the fair value of assets under trust management. Revenues from fiduciary activities of $4.7 million in 2002 were flat as compared to 2001 and decreased 4.2% to $4.7 million in 2001 from $4.9 million in 2000 primarily due to declines in market values of underlying assets.
The Company recorded net OREO income of $179,000 in 2002 as compared to net OREO expense of $130,000 in 2001 and net OREO income of $689,000 in 2000. Variations in net OREO income or expense during the periods is primarily the result of fluctuations in gains and losses on sales of OREO. OREO income or expense is directly related to prevailing economic conditions, and such income could decrease significantly should an unfavorable shift occur in the economic conditions of the Company’s markets.
Net investment securities gains of $2.5 million in 2002 increased from $145,000 in 2001 and $133,000 in 2000. Gains on investment securities in 2002 were primarily offset by impairment charges on capitalized mortgage servicing rights.
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Exclusive of one-time reinsurance revenues of $1.3 million (offset by corresponding one-time charges of $1.1 million recorded in other expense), other income increased 27.4% to $5.6 million in 2002 as compared to 2001 primarily due to a $1.2 million gain on the sale of net assets of a banking office and increases in the cash surrender value of life insurance resulting from the purchase of $50 million of bank-owned life insurance. Other income increased 41.6% to $5.7 million in 2001 from $4.0 million in 2000 primarily due to one-time premium revenues of $1.3 million related to establishment of a reinsurance program for credit-related life and disability insurance (see discussion of increases in other operating expenses herein). In addition, during 2001, the Company recorded non-recurring revenue related to the demutualization of life insurance company stock and the partial recovery of three previously recorded non-credit losses.
Noninterest Expense
Noninterest expense increased 11.3% to $133.8 million in 2002 from $120.2 million in 2001 and increased 18.7% to $120.2 million in 2001 from $101.3 million in 2000. Significant components of these increases are discussed below.
Salaries, wages and employee benefits expenses increased 11.0% to $68.4 million in 2002 from $61.6 million in 2001 primarily due to inflationary wage increases, higher staffing levels associated with internal growth and rising group health insurance costs. Increases in 2002 as compared to 2001 were partially offset by a $473,000 decrease in compensation expense related to outstanding stock options. Salaries, wages and employee benefits expense increased 18.9% to $61.6 million in 2001 from $51.8 million in 2000. Approximately 28% of the increase is directly attributable to new banking offices opened or acquired since June 2000. In addition, $1.1 million of the increase is due to compensation expense related to outstanding stock options. The remaining increase is primarily due to increases in administrative staffing levels to support the Company’s expanding number of banking offices, increases in group health insurance premiums and inflationary wage increases. For additional information related to the Company’s Stock Option Plans, see “Notes to Consolidated Financial Statements – Employee Benefit Plans” included in Part IV, Item 15.
Occupancy expense increased 10.4% to $10.6 million during 2002 from $9.6 million in 2001 primarily due to additional rent expense associated with internal growth and higher maintenance and repair expenses associated with upgrades of existing facilities. Occupancy expense increased 18.6% to $9.6 million in 2001 from $8.1 million in 2000 primarily due to additional rent and depreciation expenses associated with internal growth, bank acquisitions and the remodeling of existing facilities.
Furniture and equipment expense increased 7.4% to $13.2 million in 2002 from $12.3 million in 2001 primarily due to depreciation and maintenance expenses associated with the upgrade of existing facilities, the addition of new facilities and technology upgrades. Furniture and equipment expenses increased 14.7% to $12.3 million in 2001 from $10.7 million in 2000. Approximately 26% of this increase is directly attributable to new banking offices opened or acquired since June 2000. The remaining increase is largely due to maintenance and depreciation expenses associated with the Company’s continued upgrade of facilities and depreciation expense associated with furnishing the Company’s item proof and capture facilities in Colorado and Idaho.
FDIC insurance premiums of $456,000 remained stable in 2002 compared to $442,000 in 2001 and $438,000 in 2000. FDIC insurance rates in 2002, 2001 and 2000 reflect the Company’s well-capitalized rating.
The Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” on January 1, 2002. Under the provisions of SFAS No. 142, the unallocated excess purchase price over the fair value of identifiable net assets from acquisitions (“goodwill”) is no longer amortized. Goodwill amortization expense increased 9.0% to $2.2 million in 2001 from $2.0 million in 2000 due to acquisitions in 2000. For additional information regarding goodwill, see “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included n Part IV, Item 15.
Core deposit intangibles amortization expense decreased 10.7% to $1.3 million in 2002 as compared to $1.4 million in 2001 and 2000 primarily due to scheduled decreases based on the Company’s amortization method.
Other expenses primarily include advertising and public relations costs; legal, audit and other professional fees; office supply, postage, freight and telephone expenses; and, mortgage servicing rights amortization and impairment charges. Exclusive of one-time reinsurance expenses of $1.1 million recorded in 2001, other expenses increased 26.3% to $40.0 million in 2002 as compared to 2001. During 2002, the Company recorded impairment of $2.5 million on mortgage servicing rights and accelerated amortization on the remaining mortgage servicing rights resulting in additional amortization expense of $1.6 million. In addition, the Company recorded impairment charges of $1.3 million on equipment pending disposition. The remaining increase in 2002 as compared to 2001 is primarily due to higher public
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relation, donation, travel and unreimbursed loan expenses combined with normal inflationary expense increases. Other expenses increased 21.8% to $32.7 million in 2001 from $26.9 million in 2000. Approximately 22% of this increase is attributable to new banking offices opened or acquired since June 2000. In addition, during 2001 the Company recorded one-time insurance reserves and claims expense of $1.1 million related to establishment of a reinsurance program for credit-related life and disability insurance and impairment of capitalized mortgage servicing rights of $1.1 million. The remaining increase is primarily due to employee education, professional fees related to regulatory reporting and increases in ATM, postage, express mail, supply and telephone expenses.
Income Tax Expense
The Company’s effective federal tax rate was 29.8%, 30.7%, and 31.3% for the years ended December 31, 2002, 2001 and 2000, respectively. State income tax applies only to pretax earnings of entities operating within Montana, Colorado and Idaho. The Company’s effective state tax rate was 6.1%, 5.8%, and 4.8% for years ended December 31, 2002, 2001 and 2000, respectively.
Business Line Results
The Company is managed along two primary lines of business, Community Banking and Technology Services. Community Banking encompasses commercial and consumer banking services provided to individual customers, businesses and municipalities. These services primarily include the acceptance of deposits, extension of credit and fee-based investment services, mortgage origination and mortgage servicing.
Technology Services encompasses services provided by i_Tech to affiliated and non-affiliated customers including core application data processing, ATM processing support, item proof and capture, wide area network services and system support.
Additional information regarding the Company’s business lines, see “Notes to Consolidated Financial Statements – Business Line Reporting” included in Part IV, Item 15.
Community Banking net income increased 7.9% to $40.6 million in 2002 from $37.7 million in 2001 primarily due to internal growth in net interest income and increases in processing and origination fees on residential real estate loans sold in the secondary market. Additionally, Community Banking recorded gains of $2.3 million on sales of investment securities and $1.2 million on the sale of the net assets of a banking office. Increases in net interest and noninterest income were partially offset by increases in provisions for loan losses of $1.7 million, recognition of impairment of $2.8 million on capitalized mortgage servicing rights and an acceleration in amortization of remaining mortgage servicing rights of $1.6 million. In addition, salary and benefits, occupancy, furniture and equipment and other expenses increased in 2002 primarily due to inflation and additional costs associated with internal growth. Expense increases were partially offset by the discontinuation of amortization of goodwill.
Community banking net income increased 10.4% to $37.7 million in 2001 from $34.1 million in 2000 primarily due to internally generated growth in net interest income and increases in processing and origination fees on residential real estate loans sold in the secondary market. These increases were partially offset by net losses incurred by new banking offices opened or acquired since June 2000 and increases in administrative staffing levels to support the Company’s expanding number of banking offices
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Technology Services net income increased 3.8% to $3.2 million in 2002 from $3.1 million in 2001 primarily due to increases in core data processing revenues and higher ATM transaction volumes. Increases in revenues were partially offset by decreases in interest income, inflationary expense increases and higher travel expense. Technology services revenues increased 3.2% to $3.1 million in 2001 from $3.0 million in 2000 primarily due to increases in core data processing revenues from affiliates.
Other includes the net funding cost of the Parent Company, compensation expense or benefit related to stock-based employee compensation, the operating results of non-bank subsidiaries except i_Tech and intercompany eliminations. Other net losses decreased 2.3% to $9.3 million in 2002 from $9.5 million in 2001 primarily due to decreases in interest expense on long-term debt, lower provisions for loan losses and decreases in compensation expense related to outstanding stock options. These cost savings were partially offset by impairment charges of $1.3 million related to equipment pending disposition. Other net losses increased 42.4% to $9.5 million in 2001 from $6.7 million in 2000 primarily due to increases in compensation expense related to outstanding stock options, increases in interest expense primarily due to borrowings used to fund an acquisition in 2000, increases in salaries, wages and employee benefits expenses and the establishment of an allowance for loan losses by the Parent Company.
For additional information regarding the Company’s lines of business, see “Notes to Consolidated Financial Statements – Business Line Reporting” included in Part IV, Item 15.
Financial Condition
Total assets increased 8.5% to $3,559 million as of December 31, 2002 from $3,279 million as of December 31, 2001. This increase was due to internal growth in loans, increases in investment securities and the acquisition of $50 million of bank-owned life insurance. Growth was funded primarily by increases in customer deposits.
Loans
Total loans increased 5.4% to $2,237 million as of December 31, 2002 from $2,122 million as of December 31, 2001. The most significant growth occurred in loans secured by commercial and residential real estate and construction loans. Total loans increased 7.6% to $2,122 million as of December 31, 2001 from $1,972 million as of December 31, 2000. Loan growth in 2002 and 2001 is primarily the result of expansion in the Company’s market presence through a combination of marketing activities and branch openings.
The Company’s loan portfolio consists of a mix of real estate, consumer, commercial, agricultural and other loans, including fixed and variable rate loans. Fluctuations in the loan portfolio are directly related to the economies of the communities served by the Company. Thus, the Company’s borrowers could be adversely impacted by a downturn in local economies that could have a material adverse effect on the borrowers’ abilities to repay their loans.
The following table presents the composition of the Company’s loan portfolio as of the dates indicated:
Loans Outstanding
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The following table presents the maturity distribution of the Company’s loan portfolio and the sensitivity of the loans to changes in interest rates as of December 31, 2002:
Maturities and Interest Rate Sensitivities
For additional information concerning the Company’s loan portfolio and its credit administration policies, see Part I, Item 1, “Business-Lending Activities.”
Investment Securities
The Company’s investment portfolio is managed to attempt to obtain the highest yield while meeting the Company’s risk tolerance and liquidity needs and to satisfy pledging requirements for deposits of state and political subdivisions and securities sold under repurchase agreements. The portfolio is comprised of U.S. government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and mutual funds. Federal funds sold are additional investments that are classified as cash equivalents rather than as investment securities. Investment securities classified as available-for-sale are recorded at fair value, while investment securities classified as held-to-maturity are recorded at amortized cost. Unrealized gains or losses, net of the deferred tax effect, on available-for-sale securities are reported as increases or decreases in accumulated other comprehensive income or loss, a component of stockholders’ equity.
Investment securities increased 15.3% to $799 million as of December 31, 2002 from $693 million as of December 31, 2001 and 12.9% to $693 million as of December 31, 2001 from $614 million as of December 31, 2000 primarily due to investment of funds generated through internal deposit growth.
On January 1, 2001, the Company adopted the provision of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” In conjunction with the initial application of SFAS No. 133, the Company transferred held-to-maturity investment securities with amortized costs and fair values of $104 million and $103 million, respectively, to available-for-sale investment securities to better conform to the Company’s investment objectives. Upon adoption of SFAS No. 133, the Company recorded as comprehensive income net unrealized holding losses of $569,000, net of tax, related to the transferred securities.
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The following table sets forth the book value, percentage of total investment securities and average yield for the Company’s investment securities as of December 31, 2002:
Securities Maturities and Yield
The maturities noted above reflect $155,805 of investment securities at their final maturities although they have call provisions within the next year. Mortgage-backed securities, and to a limited extent other securities, have uncertain cash flow characteristics that present additional interest rate risk to the Company in the form of prepayment or extension risk primarily caused by changes in market interest rates. This additional risk is generally rewarded in the form of higher yields. Maturities of mortgage-backed securities presented above are based on current prepayment assumptions.
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As of December 31, 2001, the Company had U.S. Treasury securities, U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities, equity securities and mutual funds with carrying values of $22,564, $169,925, $83,327, $16,747, $354,310, $175 and $46,130, respectively.
As of December 31, 2000, the Company had U.S. Treasury securities, U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and equity securities with carrying values of $66,377, $240,972, $78,640, $41,970, $185,549 and $200, respectively.
For additional information concerning investment securities, see “Notes to Consolidated Financial Statements – Investment Securities” included in Part IV, Item 15.
Mortgage Servicing Rights
The Company recognizes the rights to service mortgage loans for others whether acquired or internally originated. Mortgage servicing rights increased 33.0% to $8 million as of December 31, 2002 from $6 million as of December 31, 2001 and 27.4% to $6 million as of December 31, 2001 from $4 million as of December 31, 2000 primarily due to internal loan origination. Impairment reserves on mortgage servicing rights were $4 million as of December 31, 2002, compared to $1 million as of December 31, 2001. No impairment reserves existed at December 31, 2000. For additional information regarding the Company’s mortgage servicing rights, see “Notes to Consolidated Financial Statements – Mortgage Servicing Rights” included in Part IV, Item 15.
Other Assets
Other assets primarily include restricted equity securities of government agencies and the cash surrender value of life insurance policies. Other assets increased 113.3% to $86 million as of December 31, 2002 from $40 million as of December 31, 2001 primarily due to the purchase of $50 million of bank-owned life insurance. This increase was partially offset by the redemption of equity securities issued by the Federal Home Loan Bank. Other assets increased 17.6% to $40 million as of December 31, 2001 from $34 million as of December 31, 2000 primarily due to increases in Federal Reserve Bank restricted equity securities. For additional information on the Company’s insurance policies, see “Notes to Consolidated Financial Statements – Cash Surrender Value of Life Insurance” included in Part IV, Item 15.
Deposits
The Company emphasizes developing total client relationships with its customers in order to increase its core deposit base, which is the Company’s primary funding source. The Company’s deposits consist primarily of noninterest bearing and interest bearing demand, savings, IRA and time deposit accounts. Deposits increased 8.9% to $2,912 million as of December 31, 2002 from $2,673 million as of December 31, 2001 due to internal growth. The most significant growth occurred in interest bearing demand and savings deposits. Deposits increased 13.0% to $2,673 million as of December 31, 2001 from $2,365 million as of December 31, 2000 due to internal growth occurring primarily in noninterest bearing demand and savings deposits.
In addition to deposits, the Company also uses other traditional funding sources to support its earning asset portfolio including other borrowed funds consisting primarily of tax deposits due to the Federal government, repurchase agreements with commercial depositors and, on a seasonal basis, Federal funds purchased.
For additional information concerning customer deposits, including its use of repurchase agreements, see Part I, Item 1, “Business – Funding Sources” and “Notes to Consolidated Financial Statements — Deposits” included in Part IV, Item 15.
Other Borrowed Funds
Other borrowed funds remained stable at $8 million as of December 31, 2002 and 2001 and decreased 27.3% to $8 million as of December 31, 2001 from $11 million as of December 31, 2000 primarily due to timing of tax deposits made by customers and the subsequent withdrawal of funds by the Federal government. For additional information on other borrowed funds as of December 31, 2002 and 2001, see “Notes to Consolidated Financial Statements – Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
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Federal Funds Purchased and Securities Sold Under Repurchase Agreements
The following table sets forth certain information regarding Federal funds purchased and repurchase agreements as of the dates indicated:
Long-Term Debt
The Company’s long-term debt is comprised principally of an unsecured revolving term loan and unsecured subordinated notes. Long-term debt decreased 31.1% to $24 million as of December 31, 2002 from $34 million as of December 31, 2001 and 8.1% to $34 million as of December 31, 2001 from $37 million as of December 31, 2000 primarily due to principal paydowns. For additional information on long-term debt as of December 31, 2002 and 2001, see “Notes to Consolidated Financial Statements – Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
Trust Preferred Securities
The Company had trust preferred securities of $40 million at December 31, 2002, 2001 and 2000. For additional information on trust preferred securities, see “Notes to Consolidated Financial Statements – Trust Preferred Securities” included in Part IV, Item 15.
Non-Performing Assets
Non-performing assets include loans past due 90 days or more and still accruing interest, non-accrual loans, loans renegotiated in troubled debt restructurings and OREO. Management generally places loans on nonaccrual when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed from income. Approximately $1.7 million, $1.7 million, $1.9 million, $1.4 million and $1.1 million of gross interest income would have been accrued if all loans on nonaccrual had been current in accordance with their original terms for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively.
Restructured loans are loans on which the Company has granted a concession on the interest rate or original repayment terms due to financial difficulties of the borrower.
OREO consists of real property acquired through foreclosure on the related collateral underlying defaulted loans. The Company initially records OREO at the lower of carrying value or fair value less estimated costs to sell by a charge against the allowance for loan losses, if necessary. Estimated losses that result from the ongoing periodic valuation of these properties are charged to earnings with a provision for losses on foreclosed property in the period in which they are identified.
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The following table sets forth information regarding non-performing assets as of the dates indicated:
Non-performing assets increased 28.8% to $35 million as of December 31, 2002 from $27 million as of December 31, 2001 due to increases in nonaccrual loans. Approximately 60% of the increase in nonaccrual loans is due to one commercial and one agricultural borrower adversely affected by drought conditions in the Company’s market areas. Non-performing assets decreased 11.9% to $27 million as of December 31, 2002 compared to $30 million as of December 31, 2001 primarily due to decreases in nonaccrual loans and sales of OREO. Loans past due 90 days or more and still accruing interest as of December 31, 2001 includes one matured commercial loan of $2 million in the process of being renewed.
In addition to the non-performing loans included in the table above, management has serious doubts as to the ability of certain borrowers to comply with the present repayment terms on performing loans which may result in future non-performing loans. There can be no assurance that the Company has identified all of its potential non-performing loans. Furthermore, management cannot predict the extent to which economic conditions in the Company’s market areas may worsen or the full impact such conditions may have on the Company’s loan portfolio. Accordingly, there can be no assurances that other loans will not become 90 days or more past due, be placed on nonaccrual, be renegotiated or become OREO in the future.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of known and inherent risk in its loan portfolio. See “Provision for Loan Losses” herein. The allowance for loan losses is increased by provisions charged against earnings and reduced by net loan charge-offs. Loans are charged-off when management determines that collection has become unlikely. Consumer loans are generally charged off when they become 120 days past due. Other loans, or portions thereof, are charged off when they become 180 days past due unless they are well-secured and in the process of collection. Recoveries are recorded only when cash payments are received.
The allowance for loan losses is maintained at an amount to sufficiently provide for estimated losses based on management’s evaluation of known and inherent risks in its loan portfolio at each balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposures from outstanding loans. For commercial, agricultural and real estate loans, loss factors are applied based on the internal risk classifications of these loans. For certain consumer loans, loss factors are applied on a portfolio basis. Loss factors are based on peer and industry loss data which are comparable to the Company’s historical loss experience, and are reviewed on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio such as changes in the size and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions and detailed analyses of individual loans for which full collectibility may not be assured.
Specific allowances are established for loans where management has determined that the probability of a loss exists and will exceed the historical loss factors specifically identified based on the internal risk classification of the loans. The unallocated component of the allowance for loan losses recognizes estimates of losses inherent in the portfolio that are not fully captured in the specific allowances that may result from model imprecision, changes in the
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nature and volume of the loan portfolio, overall portfolio quality, industry concentrations, current economic factors and the estimated impact of current economic conditions on historical loss rates used in the allocated model.
Management has assessed, and will continue to assess on an on-going basis, the impact of slowing national, regional and local economies on credit risk in the loan portfolio. As of December 31, 2002, delinquency trends and classified loan levels relative to prior periods do not indicate a significant deterioration in the loan portfolio. Management continues to closely monitor credit quality and to focus on identifying potential non-performing loans and loss exposure in a timely manner.
The following table sets forth information concerning the Company’s allowance for loan losses as of the dates and for the years indicated.
The allowance for loan losses was $36 million, or 1.62% of period end loans, at December 31, 2002 as compared to $34 million, or 1.61% of period end loans, at December 31, 2001 and $33 million, or 1.66% of period end loans, at December 31, 2000. Net charge-offs of $7.0 million in 2002 increased from $6.6 million in 2001 and $3.1 million in 2000. Increases in net charge-offs in 2002 as compared to 2001 occurred primarily in commercial and agricultural loans. Increases in net charge-offs in 2001 as compared to 2000 occurred primarily in consumer and commercial loans due to a slight deterioration in the consumer loan portfolio and net commercial loan charge-offs largely related to six borrowers.
Although management believes that it has established its allowance for loan losses in accordance with accounting principles generally accepted in the United States and that the allowance for loan losses is adequate to provide for known and inherent losses in the portfolio at each balance sheet date, future provisions will be subject to on-going evaluations of the risk in the portfolio. If the economy declines or asset quality deteriorates, material additional provisions could be required.
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The allowance for loan losses is allocated to loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. Management has reviewed the allocations and believes the allowance for loan losses was adequate at all times during the five-year period ended December 31, 2002. The following table provides a summary of the allocation of the allowance for loan losses for specific loan categories as of the dates indicated. The allocations presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amount available for future losses that may occur within these categories. The unallocated portion of the allowance for loan losses and the total allowance is applicable to the entire loan portfolio.
The allocated reserve for consumer loans increased 15.4% to $5.9 million in 2002 from $5.1 million in 2001 primarily due to softening economic conditions in the Company’s market areas and continued slight deterioration in the indirect consumer loan and credit card portfolios. The allocated reserve for commercial loans increased 13.8% to $8.0 million in 2002 from $7.0 million in 2001 primarily due to the economic effects of drought conditions and a general softening of economic conditions in the Company’s market areas. The allocated reserve for agricultural loans increased 24.6% to $3.3 million in 2002 from $2.7 million in 2001 primarily due to the downgrade of loans of one borrower.
The allocated reserve for consumer loans increased 10.3% to $5.1 million in 2001 from $4.6 million in 2000 primarily due to improved tracking and monitoring of credit card losses. Prior to 2001, credit card reserves were included in the unallocated reserve. The allocated reserve for commercial loans increased 30.9% to $7.0 million in 2001 from $5.4 million in 2000. Approximately 80% of this increase is due to the downgrade of five commercial loans. The unallocated reserve decreased 11.4% to $7.9 million in 2001 from $9.0 million in 2000 primarily due to the allocation of credit card reserves to consumer loans and additional amounts allocated to loan categories resulting from application of loss factors to the portfolio.
Liquidity and Cash Flow
The objective of liquidity management is to maintain the Company’s ability to meet the day-to-day cash flow requirements of its customers who either wish to withdraw funds or require funds to meet their credit needs. The Company manages its liquidity position to meet the needs of its customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of its shareholders. The Company monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position, principally through deposit receipts and check payments; loan originations, extensions and repayments; and, management of investment securities.
The Company’s current liquidity position is also supported by the management of its investment portfolio, which provides a flow of reinvestable cash. Maturing balances in the Company’s loan portfolio also provide options for cash flow management. The ability to redeploy these funds is an important source of immediate to long-term liquidity. Additional sources of liquidity include customer deposits, Federal funds lines, borrowings and access to capital markets. The Company does not rely on off-balance sheet arrangements to provide financing, liquidity or market or credit risk support, nor does it engage in derivatives and related hedging activities.
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Net cash provided by operating activities, primarily net income, totaled $67 million in 2002, $48 million in 2001 and $47 million in 2000. Net cash used in investing activities totaled $317 million in 2002, $274 million in 2001 and $235 million in 2000. Investing activities principally include investment security transactions and net extensions of credit to customers. Net cash provided by financing activities, primarily generated through increases in customer deposits, borrowing advances or issuance of securities or stock, totaled $268 million in 2002, $350 million in 2001 and $195 million in 2000. For additional information concerning cash flows, see the “Consolidated Statements of Cash Flows” included in Part IV, Item 15.
As a holding company, FIBS is a corporation separate and apart from the Bank, and therefore, provides for its own liquidity. Substantially all of FIBS’s revenues are obtained from management fees and dividends declared and paid by the Bank. As of December 31, 2002, the Bank had approximately $47.7 million available to be paid as dividends to FIBS. However, there are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to FIBS. In addition, to maintain its “well-capitalized” standing with the Federal Reserve Board, the amount available to be paid as dividends to FIBS is limited to approximately $30.5 million. See Part I, Item 1, “Business-Regulation and Supervision.” Management of FIBS believes that such restrictions will not have an impact on the ability of FIBS to meet its ongoing cash obligations.
In connection with acquisitions in 1996, the Company issued subordinated notes. The subordinated notes are held by an institutional investor, bear interest at 7.5% per annum, are unsecured and mature in increasing annual payments during the period from October 2002 to October 2006. For additional information concerning the revolving term loan and the subordinated notes, see “Notes to Consolidated Financial Statements — Long Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
The trust preferred securities are unsecured, bear interest at a rate of 8.625%, and mature on December 1, 2027. Interest distributions are payable quarterly, however, the Company may defer interest payments at any time for a period not exceeding 20 consecutive quarters. The trust preferred securities may be redeemed prior to maturity at the Company’s option on or after December 1, 2002. The Company has guaranteed the payment of distributions and payments for redemption or liquidation of the trust preferred securities to the extent of funds held by FIB Capital. For additional information concerning the trust preferred securities see “Notes to Consolidated Financial Statements — Trust Preferred Securities” included in Part IV, Item 15.
Capital Resources
Stockholders’ equity increased 9.8% to $244 million as of December 31, 2002 from $222 million as of December 31, 2001 and 12.1% to $222 million as of December 31, 2001 from $198 million as of December 31, 2000, primarily due to increases in retained earnings. Stockholders’ equity is influenced primarily by earnings, dividends and, to a lesser extent, sales and redemptions of common stock and changes in the unrealized holding gains or losses, net of taxes, on available-for-sale investment securities. For the years ended December 31, 2002, 2001 and 2000, the Company paid aggregate cash dividends to stockholders of $10.1 million, $9.3 million and $8.8 million, respectively.
Pursuant to FDICIA, the Federal Reserve and the FDIC have adopted regulations setting forth a five-tier system for measuring the capital adequacy of the financial institutions they supervise. At December 31, 2002, the Bank had a capital level that exceeded the well-capitalized guidelines. For additional information concerning the capital levels of the Company, see “Notes to Consolidated Financial Statements — Regulatory Matters” contained in Part IV, Item 15.
Interest Rate Risk Management
The Company’s primary earnings source is the net interest margin, which is affected by changes in the level of interest rates, the relationship between rates, the impact of interest rate fluctuations on asset prepayments and the mix of interest bearing assets and liabilities.
The ability to optimize the net interest margin is largely dependent upon the achievement of an interest rate spread that can be managed during periods of fluctuating interest rates. Interest sensitivity is a measure of the extent to which net interest income will be affected by market interest rates over a period of time. Interest rate sensitivity is related to the difference between amounts of interest earning assets and interest bearing liabilities which either reprice or mature within a given period of time. The difference is known as interest rate sensitivity gap.
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The following table shows interest rate sensitivity gaps for different intervals as of December 31, 2002:
As noted in footnote 3 above, interest bearing demand accounts and savings deposits are allocated based on historical analysis of their interest rate sensitivity characteristics although they are technically subject to immediate withdrawal. If these deposits were included in the three month or less category, the above table would reflect a negative three month gap of $636 million, a negative cumulative one year gap of $513 million and a positive cumulative one to five year gap of $234 million.
The balance sheet structure is primarily short-term in nature with most assets and liabilities repricing or maturing in less than five years. Management monitors the sensitivity of net interest margin by utilizing income simulation models and a traditional interest rate gap analysis. The income simulation model involves a degree of estimation based on certain assumptions management believes to be reasonable including estimated cash flows, prepayments, repricing characteristics, maturities, deposit growth and retention, and the relative sensitivity of assets and liabilities to change in market interest rates. The relative sensitivity is important to consider since the Company’s deposit base is not subject to the same degree of interest sensitivity as its assets.
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The Company targets a mix of interest earning assets and deposits such that no more than 5% of the net interest margin will be at risk over a one-year period should interest rates vary one percent. As of December 31, 2002, the Company’s income simulation models predict approximately 7.8% of the net interest margin is at risk over a one-year period should interest rates decline one percent. Management considers the possibility of interest rates declining by 1% during 2003 as highly unlikely. In evaluating exposure to interest rate risk, management does not view the gap amounts in the preceding table as presenting an unusually high risk potential. However, no assurances can be given that the Company is not at risk in the event of rate increases or decreases and there can be no assurance as to the actual effect changes in interest rates will have on the Company’s net interest margin.
Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. For additional information regarding the allowance for loan losses, its relation to the provision for loan losses and risk related to asset quality, see “Business – Risk Factors – Asset Quality” included in Part 1, Item 1; “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Provision for Loan Losses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Allowance for Loan Losses” included in Part II, Item 7; and, “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies – Allowance for Loan Losses” included in Part IV, Item 15.
Recent Accounting Pronouncements
New accounting policies adopted by the Company during 2002 and the expected impact of accounting standards recently issued but not yet adopted are discussed in “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included in Part IV, Item 15.
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Quarterly Summary
The following table presents the Company’s unaudited quarterly results of operations for the fiscal years ended December 31, 2002 and 2001.
Net income for the fourth quarter of 2002 was $8.6 million, or $1.10 per diluted share, compared to $8.4 million, or $1.07 per diluted share, for the third quarter of 2002 and $7.7 million, or $0.99 per diluted share, for the fourth quarter of 2001. The improvement in linked-quarter results is primarily due to increases in fees on real estate loans sold in the secondary market. The improvement in year-over-year quarter results is primarily due to increases in fees on real estate loans sold in the secondary market and decreases in the provision for loan losses.
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Net interest income for the fourth quarter of 2002 was $33.1 million, compared to $34.7 million for the third quarter of 2002 and $33.8 million for the fourth quarter of 2001. On a fully-taxable equivalent basis, the net yield on interest earning assets was 4.30% for the fourth quarter of 2002, compared to 4.63% for the third quarter of 2002 and 4.74% for the fourth quarter 2001. Declines in linked-quarter and year-over-year quarter results are largely due to compression in the net yield on interest earning assets resulting from declining interest rates. In addition, declines in interest rates have led to significant prepayments of higher yielding investment securities which have been replaced with investments yielding current market rates.
The provision for loan losses was $2.5 million for the fourth quarter of 2002, compared to $2.1 million for the third quarter of 2002 and $3.0 million for the fourth quarter of 2001. For further discussion regarding the provision for loan losses, see “Provision for Loan Losses” and “Allowance for Loan Losses” included herein.
Noninterest income was $16.1 million for the fourth quarter of 2002, compared to $17.7 million for the third quarter of 2002 and $14.9 million for the fourth quarter of 2001. Included in noninterest income for 2002 is a $1.2 million gain on the sale of net assets of a banking office and gains of $2.3 million on investment securities sold principally to offset impairment charges on capitalized mortgage servicing rights. Increases in noninterest income for the fourth quarter of 2002 as compared to fourth quarter 2001 are primarily due to fees on real estate loans sold in the secondary market, service charges on deposit accounts and higher debit card and ATM transaction volumes. These increases were partially offset by decreases in reinsurance premium revenues, the result of a one-time credit of $1.3 million to establish a reinsurance program during the fourth quarter of 2001.
Noninterest expense for the fourth quarter of 2002 was $33.5 million, compared to $37.2 million in the third quarter of 2002 and $33.4 million in the fourth quarter of 2001. Noninterest expense for 2002 included impairment charges related to capitalized mortgage servicing rights of $2.8 million during the third quarter. Noninterest expense for 2001 included one-time claims expense of $1.1 million related to establishment of a reinsurance program during fourth quarter.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
The Company’s primary market risk exposure is interest rate risk. The business of the Company and the composition of its balance sheet consists of investments in interest earning assets (principally loans and investment securities) which are primarily funded by interest bearing liabilities (deposits and indebtedness). Such financial instruments have varying levels of sensitivity to changes in market interest rates. Interest rate risk results when, due to different maturity dates and repricing intervals, interest rate indices for interest earning assets decrease relative to interest bearing liabilities, thereby creating a risk of decreased net earnings and cash flow.
The following tables provide information about the Company’s market sensitive financial instruments, categorized by maturity and the instruments’ fair values at December 31, 2002 and 2001. The table constitutes a “forward-looking statement.” For a description of the Company’s policies with respect to managing risks associated with changing interest rates, see Part I, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition-Interest Rate Risk Management.”
Although the Company characterizes some of its interest-sensitive assets as securities available-for-sale, such securities are not purchased with a view to sell in the near term. Rather, such securities may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk. Thus, all interest-sensitive assets described below are non-trading. See “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
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The prepayment projections of net loans are based on experience and do not take into account any allowance for loan losses. The expected maturities of securities are based upon contractual maturities adjusted for projected prepayments of principal and assumes no reinvestment of proceeds. The actual maturities of these instruments could vary substantially if future prepayments differ from the Company’s historical experience. All other financial instruments are stated at contractual maturities.
Item 8. Financial Statements and Supplementary Data
The following Consolidated Financial Statements of FIBS and subsidiaries are contained elsewhere herein [see Item 15(a)1]:
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There have been no changes in or disagreements with accountants on accounting and financial disclosure.
PART III
Item 10. Directors and Executive Officers of Registrant
Information concerning “Directors and Executive Officers of Registrant” is set forth under the heading “Directors and Executive Officers” in the Company’s Proxy Statement and is herein incorporated by reference.
Information concerning “Compliance With Section 16(a) of the Securities and Exchange Act of 1934” is set forth under the heading “Compliance With Section 16(a) of the Securities and Exchange Act of 1934” (the “Exchange Act”) in the Company’s Proxy Statement and is herein incorporated by reference.
Item 11. Executive Compensation
Information concerning “Executive Compensation” is set forth under the heading “Director and Executive Compensation” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information concerning “Security Ownership of Certain Beneficial Owners and Management” is set forth under the heading “Security Ownership of Principal Shareholders and Management” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 13. Certain Relationships and Related Transactions
Information concerning “Certain Relationships and Related Transactions” is set forth under the heading “Certain Relationships and Related Transactions” in the Company’s Proxy Statement and is herein incorporated by reference. In addition, see “Notes to Consolidated Financial Statements – Related Party Transactions” included in Part IV, Item 15.
Item 14. Disclosure Controls and Procedures
Management of the Company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934. As of December 31, 2002, an evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, management concluded that the Company’s disclosure controls and procedures as of December 31, 2002 were effective in ensuring that information required to be disclosed in this Annual Report on Form 10-K was recorded, processed, summarized, and reported within the time period required by the SEC’s rules and forms.
Management’s responsibilities related to establishing and maintaining effective disclosure controls and procedures include maintaining effective internal controls over financial reporting that are designed to produce reliable financial statements in accordance with accounting principles generally accepted in the United States. Management assessed the Company’s system of internal controls over financial reporting as of December 31, 2002, in relation to criteria for effective internal controls over financial reporting. Based on this assessment, management believes that, as of December 31, 2002, its system of internal controls over financial reporting met those criteria.
There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to December 31, 2002.
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. Following are the Company’s audited consolidated financial statements.
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REPORT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS
The Board of Directors and StockholdersFirst Interstate BancSystem, Inc.
We have audited the accompanying consolidated balance sheets of First Interstate BancSystem, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for the years then ended. These financial statements are the responsibility of First Interstate BancSystem, Inc.’s management. Our responsibility is to express an opinion on these financial statements based on our audits. The consolidated financial statements of First Interstate BancSystem, Inc. and subsidiaries for the year ended December 31, 2000 were audited by other auditors whose report dated January 26, 2001, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 2002 and 2001 financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Interstate BancSystem, Inc. and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Salt Lake City, UtahFebruary 6, 2003
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REPORT OF KPMG LLP INDEPENDENT AUDITORS
Independent Auditors’ Report
The Board of Directors and StockholdersFirst Interstate BancSystem, Inc.:
We have audited the accompanying consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows of First Interstate BancSystem, Inc. and subsidiaries for the year ended December 31, 2000. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of First Interstate BancSystem, Inc. and subsidiaries for the year ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Billings, MontanaJanuary 26, 2001
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIES
Consolidated Balance Sheets(In thousands, except share data)
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Income(In thousands, except per share data)
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Consolidated Statements of Stockholders’ Equity and Comprehensive Income(In thousands, except share and per share data)
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Consolidated Statements of Cash Flows(Dollars in thousands)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands, except share and per share data)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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(2) REGULATORY CAPITAL
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(3) INVESTMENT SECURITIES
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First Interstate BancSystem, Inc. and Subsidiaries
Notes to Consolidated Financial Statements(Dollars in thousands, except share and per share data)
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Exhibit Index
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d)of the Act by Registrants which have not Registered Securities Pursuant to Section 12 of the Act
The Registrant has not yet provided any annual report to security holders covering the 2002 fiscal year, nor has any proxy statement, form of proxy or other proxy soliciting material been sent to any security holder of the Registrant with respect to the Registrant’s 2003 annual meeting of shareholders. If any such annual report or proxy material is sent to security holders subsequent to the filing of this Annual Report on Form 10-K, the Registrant shall furnish copies of such report and material to the Commission when it is sent to security holders.
CERTIFICATION OF ANNUAL REPORT ON FORM 10-KPURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Thomas W. Scott, certify that :
I, Terrill R. Moore, certify that :
CERTIFICATION OF ANNUAL REPORT ON FORM 10-KPURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
The undersigned are the Chief Executive Officer and the Chief Financial Officer of First Interstate BancSystem, Inc. (the “Registrant”). This Certification is made pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. This Certification accompanies the Annual Report on Form 10-K of the Registrant for the fiscal year ended December 31, 2002.
We certify that such Annual Report on Form 10-K fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that the information contained in the Form 10-K Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
This Certification is executed as of March 18, 2003.