ChoiceOne Financial Services - 10-Q quarterly report FY

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED BALANCE SHEETS

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

ChoiceOne Financial Services, Inc.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
The consolidated financial statements include ChoiceOne Financial Services, Inc. (the "Registrant") and its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and the Bank's wholly-owned subsidiary ChoiceOne Insurance Agencies, Inc. Intercompany transactions and balances have been eliminated in consolidation.

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

The accompanying consolidated financial statements reflect all adjustments ordinary in nature which are, in the opinion of management, necessary for a fair presentation of the Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009, the Consolidated Statements of Income for the three-month periods ended March 31, 2010 and March 31, 2009, the Consolidated Statements of Changes in Shareholders' Equity for the three-month periods ended March 31, 2010 and March 31, 2009, and the Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2010 and March 31, 2009. Operating results for the three months ended March 31, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 2009.

Allowance for Loan Losses
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management's evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios. See Note 2 to the interim consolidated financial statements for additional information.

Management believes the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on ChoiceOne's assets reported on the balance sheet as well as its net income.

Stock Transactions
A total of 1,234 shares of common stock were issued to the Registrant's Board of Directors for a cash price of $10,000 under the terms of the Directors' Stock Purchase Plan in the first quarter of 2010. A total of 2,155 shares were issued to employees for a cash price of $15,000 under the Employee Stock Purchase Plan for the quarter ended March 31, 2010.

Reclassifications
Certain amounts presented in prior periods have been reclassified to conform to the current presentation.

ChoiceOne Financial Services, Inc.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2 - ALLOWANCE FOR LOAN LOSSES

An analysis of changes in the allowance for loan losses follows:

NOTE 3 - EARNINGS PER SHARE

Earnings per share are based on the weighted average number of shares outstanding during the period. A computation of basic earnings per share and diluted earnings per share follows:

The estimated fair values approximate the carrying amounts for all assets and liabilities except those described later in this paragraph. The methodology for determining the estimated fair value for securities available for sale is described in Note 5. The estimated fair value for loans is based on the rates charged at March 31, 2010 for new loans with similar maturities, applied until the loan is assumed to reprice or be paid. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. The estimated fair values for time deposits and Federal Home Loan Bank advances are based on the rates paid at March 31, 2010 for new deposits or FHLB advances, applied until maturity. The estimated fair values for other financial instruments and off-balance sheet loan commitments are considered nominal.

NOTE 5 - FAIR VALUE MEASUREMENTS

The following tables present information about the Bank's assets and liabilities measured at fair value on a recurring basis and the valuation techniques used by the Bank to determine those fair values.

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Bank's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.

There were no liabilities measured at fair value as of March 31, 2010 or December 31, 2009. Disclosures concerning assets measured at fair value are as follows:

Assets Measured at Fair Value on a Recurring Basis
(Dollars in Thousands)

Changes in Level 3 Assets Measured at Fair Value on a Recurring Basis
(Dollars in Thousands)

FORWARD-LOOKING STATEMENTS

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

Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2009; changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit avail ability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

RESULTS OF OPERATIONS

Summary
Net income for the first quarter of 2010 was $644,000, which represented a decrease of $97,000 or13% compared to the same period in 2009. Growth in net interest income and noninterest income and a reduction in noninterest expense was offset by a higher provision for loan losses in the first quarter of 2010 compared to the same period in the prior year. Basic and diluted earnings per common share were $0.20 for the first quarter of 2010, compared to $0.23 for the same quarter in 2009. The return on average assets and return on average shareholders' equity percentages were .56% and 4.84%, respectively, for the first quarter of 2010, compared to .65% and 5.62%, respectively, for the same period in 2009.

Dividends
Cash dividends of $393,000 or $0.12 per share were declared in the first quarter of 2010, compared to $390,000 or $0.12 per share in the first quarter of 2009. The cash dividend payout percentage was 61% for the first three months of 2010, compared to 53% in the same period a year ago.

Interest Income and Expense
Tables 1 and 2 on the following pages provide information regarding interest income and expense for the three-month periods ended March 31, 2010 and 2009, respectively. Table 1 documents ChoiceOne's average balances and interest income and expense, as well as the average rates earned or paid on assets and liabilities. Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. These tables are referred to in the discussion of interest income, interest expense and net interest income.

Table 1 - Average Balances and Tax-Equivalent Interest Rates

Table 2 - Changes in Tax-Equivalent Net Interest Income

The average balance of interest-bearing demand deposits increased $21.3 million in the first three months of 2010 compared to the same period in 2009. The effect of the higher average balance, offset by a 9 basis point decline in the average rate paid, caused interest expense to increase $11,000 in the first quarter of 2010 compared to the same quarter in 2009. The average balance of savings deposits increased $3.9 million in the first quarter of 2010 compared to the same quarter in the prior year. The impact of the savings deposit growth was offset by an 8 basis point drop in the average rate paid, which caused interest expense to decrease $4,000 in the first three months of 2010 compared to the same period in 2009. The average balance of certificates of deposit was down $12.3 million in the first quarter of 2010 compared to the same period in 2009. The average balance of local certificates was $303,000 higher while the average balance of nonlocal certificates was $18.9 million lower in 2010 than in 2009 . The decline in certificates of deposit plus a 105 basis point reduction in the average rate paid on certificates caused interest expense to fall $524,000 in the first quarter of 2010 compared to the same period in 2009. The average balance of advances from the Federal Home Loan Bank ("FHLB") was $11.8 million lower in the first three months of 2010 than in the same period of the prior year. The average rate paid on FHLB advances was 39 basis points higher in the first quarter of 2010 than the same quarter of 2009 due to low-rate floating rate advances comprising a smaller portion of total advances in 2010 than they did in 2009. The combination of the decline in FHLB advances and the increase in the average rate paid caused interest expense to decrease $106,000 in the first three months of 2010 compared to the same period in 2009. A small decrease in the average balance of other interest-bearing liabilities in the first quarter of 2010 compared to the first quarter of 2009 plus a 16 basis point drop in the average rate paid and caused a $14,000 decrease in interest expense.

ChoiceOne's net interest income spread was 3.93% in the first quarter of 2010, compared to 3.80% for the first quarter of 2009. The growth in the interest spread was due to a 74 basis point decrease in the average rate paid on interest-bearing liabilities in the first quarter of 2010 compared to the same quarter of 2009, which was partially offset by a drop in the average rate earned on interest-earning assets of 61 basis points. The reduction in the rate paid on liabilities was due in part to aggressive repricing of local deposits as general market interest rates fell during 2009 and the first quarter of 2010. The decline in general market interest rates over the last twelve months also impacted the rates earned on interest-earning assets as the rates earned on new assets were less than the maturing assets that they replaced.

Provision and Allowance for Loan Losses
The allowance for loan losses grew $365,000 from December 31, 2009 to March 31, 2010. The allowance growth occurred in spite of a decline in total loans of $6.1 million since the end of 2009. The provision for loan losses was $1,050,000 in the first quarter of 2010, compared to $600,000 in the same period in 2009. The allowance increase resulted from the provision for loan losses exceeding net charge-offs in the first quarter of 2010 and was believed necessary due to continued concerns over the Michigan economy. While nonperforming loans decreased in the first quarter of 2010 from $14.0 million to $13.0 million, loans whose payments were past due 30 to 89 days and still accruing interest increased from $4.6 million to $7.5 million. The allowance for loan losses was 1.48% of total loans at March 31, 2010, compared to 1.34% at December 31, 2009 and 1.27% at March 31, 2009.

Charge-offs and recoveries for respective loan categories for the three months ended March 31 were as follows:

Noninterest Income
Total noninterest income increased $131,000 or 10% in the first quarter of 2010 compared to the same period in 2009. A significant increase in gains on sales of securities was partially offset by lower levels of insurance and investment commissions and gains on sales of loans. Approximately $386,000 of securities gains were recognized in the first quarter of 2010 from sales of preferred stock that represented a recovery of losses recognized on money market preferred securities in the fourth quarter of 2008. The decrease in insurance and investment commissions was primarily due to lower mutual fund and annuity sales. The reduction in gains on sales of loans resulted from a lower level of refinancing activity in the first quarter of 2010 than occurred in the same quarter in 2009.

Noninterest Expense
Total noninterest expense decreased $99,000 or 3% in the first quarter of 2010 compared to the same period in 2009. Salaries and benefits expense was down $94,000 due to lower wages, commissions, and health care costs. Data processing expense grew $50,000 due to increased numbers of accounts and volume. Supplies and postage expense was $26,000 lower due to less purchases of supplies. Other noninterest expense was $36,000 lower in the first quarter of 2010 than the same quarter in 2009 due to lower levels of directors' fees, foreclosed asset expense, and loan collection expense.

Income Tax Expense
Income tax expense was $175,000 in the first quarter of 2010 compared to $136,000 for the same quarter in 2009. The effective tax rate was 21.4% for 2010 and 15.5% for 2009. The increase in the effective tax rate was caused by lower nontaxable income from municipal securities and $95,000 of nondeductible losses on sales of preferred stock in 2010 compared to 2009.

FINANCIAL CONDITION

Securities
The securities available for sale portfolio increased $4.0 million from December 31, 2009 to March 31, 2010. Various securities totaling $12.1 million were purchased in the first three months of 2010 to replace maturities, principal repayments, and calls within the securities portfolio. Approximately $4.8 million in various securities were called or matured since the end of 2009. Principal repayments on securities totaled $1.8 million in the first three months of 2010. Approximately $2.1 million of securities were sold in the first quarter of 2010 for a net gain of $389,000.

A book gain of $386,000 and a tax loss of $95,000 were recognized from the sale of preferred stock in the first quarter of 2010. The difference was caused by losses recorded for book purposes but not tax purposes in the fourth quarter of 2008 when preferred stock was received from the unwinding of money market preferred securities.

Loans
The loan portfolio (excluding loans held for sale) declined $6.1 million from December 31, 2009 to March 31, 2010. Loan demand in the first quarter of 2010 has been sluggish due to the lackluster Michigan economy and reduced real estate values. Balances in all but commercial and industrial loans were reduced since the end of 2009, with a decrease of $2.7 million in commercial real estate loans and $1.9 million in agricultural loans contributing most of the decline.

Information regarding impaired loans can be found in Note 2 to the consolidated financial statements included in this report. The total balance of loans classified as impaired decreased from $9.7 million as of December 31, 2009 to $8.9 million as of March 31, 2010. The decrease in the first quarter of 2010 resulted from payments received on loans and charge-offs of loans, which was partially offset by loans moved to impaired status. The balance of loans with no allowance allocated decreased $117,000 in the first quarter of 2010 while the balance of loans with an allowance allocated decreased $727,000 in the same quarter. The decrease in impaired loans was due to payments received and charge-offs of loan balances in the first quarter.

As part of its review of the loan portfolio, management also monitors the various nonperforming loans. Nonperforming loans are comprised of: (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or loans past due 90 days or more, which are considered troubled debt restructurings.

The balances of these nonperforming loans were as follows:

Management reviews the capital levels of ChoiceOne and the Bank on a regular basis. The Board of Directors (the "Board") and management believe that the capital levels as of March 31, 2010 are adequate for the foreseeable future. The Board's determination of appropriate cash dividends for future periods will be based on market conditions and ChoiceOne's requirements for cash and capital.

Liquidity and Sensitivity to Interest Rates
Net cash provided from operating activities was $1.9 million for the three months ended March 31, 2010 compared to $1.6 million provided in the same period a year ago. An increase in the provision for loan losses and the net loans originated for sale was partially offset by higher gains on sales of securities and changes in other assets and liabilities. Net cash from investing activities was $1.2 million for the first quarter of 2010 compared to $11.0 million for the same period in 2009. A higher level of securities purchases and premises and equipment purchases was partially offset by a lower level of funds from securities sales. Net cash used in financing activities was $5.7 million in the quarter ended March 31, 2010 compared to $9.0 million in the same period in the prior year. The effect of a smaller reduction in FHLB advances was partially offset by less growth in deposits and a larger decline in securities sold under agreements to repurchase in 2010 than in 2009.

Management believes that the current level of liquidity is sufficient to meet the Bank's normal operating needs. This belief is based upon the availability of deposits from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds purchased from correspondent banks, and advances available from the Federal Home Loan Bank. The Bank also has a secured line of credit available from the Federal Reserve Bank.

The Bank's sensitivity to changes in interest rates is monitored by the Bank's Asset/Liability Management Committee ("ALCO"). ALCO uses a simulation model to subject rate-sensitive assets and liabilities to interest rate shocks. Assets and liabilities are subjected to an immediate 200 basis point shock up and down and the effect on net income and shareholders' equity is measured. The Bank's Interest Rate Risk Policy states that changes in interest rates cannot cause net interest income to decrease more than 10% and the market value of shareholders' equity to decrease more than 20% if rates are instantaneously shocked 200 basis points upward or downward. The rate shock computation as of March 31, 2010 increased net interest income 2% if rates rose 200 basis points and decreased net interest income less than 1% if rates fell 15 basis points. The economic value of shareholders' equity declined 8% when rates were shocked 200 basis points upward and increased less than 1% if rates were shocked 15 basis points downward. The downward interest rate shock as of March 31, 2010, was limited to 15 basis points due to the current low interest rate environment. The impact of these interest rate shocks is within the allowable policy limits established by ALCO. ALCO will continue to monitor the effect of changes in interest rates upon the Registrant's interest margin and financial condition.

Item 4.  Controls and Procedures.

An evaluation was performed under the supervision and with the participation of the Registrant's management, including the Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Registrant's disclosure controls and procedures. Based on and as of the time of that evaluation, the Registrant's management, including the Chief Executive Officer and Principal Financial Officer, concluded that the Registrant's disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that material information required to be disclosed in the reports that ChoiceOne files or submits under the Securities Exchange Act of 1934 (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be d isclosed in the reports that ChoiceOne files or submits under the Exchange Act is accumulated and communicated to management, including ChoiceOne's principal executive and principal financial officers as appropriate to allow for timely decisions regarding required disclosure. There was no change in the Registrant's internal control over financial reporting that occurred during the three months ended March 31, 2010 that has materially affected, or that is reasonably likely to materially affect, the Registrant's internal control over financial reporting.

PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings.

There are no material pending legal proceedings to which the Registrant or the Bank is a party to or to which any of their properties are subject, except for proceedings that arose in the ordinary course of business. In the opinion of management, pending or current legal proceedings will not have a material effect on the consolidated financial condition of the Registrant.

Item 1A.  Risk Factors.

There has been no material change in the risk factors reported in Item 1A of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2009.

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

On January 28, 2010, the Registrant issued 1,234 shares of common stock, without par value, to the directors of the Registrant pursuant to the Directors' Stock Purchase Plan for an aggregate cash price of $10,000. The Registrant relied on the exemption contained in Section 4(6) of the Securities Act of 1933 in connection with these sales.

ISSUER PURCHASES OF EQUITY SECURITIES

There were no purchases of equity securities by the Registrant in the first quarter of 2010. As of March 31, 2010, there are 135,668 shares remaining that may yet be purchased under approved plans or programs. The repurchase plan was adopted and announced on July 21, 2004. There is no stated expiration date. The plan authorized the repurchase of up to 50,000 shares. The Registrant's Board of Directors authorized an additional repurchase plan on July 26, 2007. There is no stated expiration date and this plan authorized ChoiceOne to repurchase an additional 100,000 shares.

Item 3.  Defaults Upon Senior Securities.

None.

Item 4.  [Item 4 of Form 10-Q has been removed and reserved by the Securities and Exchange Commission.]

Item 5.  Other Information.     None.

Item 6.  Exhibits

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

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

INDEX TO EXHIBITS

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