SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED June 30, 2005 Commission file number 0-7818 INDEPENDENT BANK CORPORATION - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Michigan 38-2032782 - --------------------------------------- ------------------------------------- (State or jurisdiction of (I.R.S. Employer Identification Incorporation or Organization) Number) 230 West Main Street, P.O. Box 491, Ionia, Michigan 48846 - -------------------------------------------------------------------------------- (Address of principal executive offices) (616) 527-9450 (Registrant's ---------------------------- telephone number, including area code) NONE - -------------------------------------------------------------------------------- Former name, address and fiscal year, if changed since last report. Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common stock, par value $1 21,183,185 - ---------------------------------- --------------------------------------- Class Outstanding at August 5, 2005
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES INDEX <TABLE> <CAPTION> Number(s) --------- <S> <C> PART I - Financial Information Item 1. Consolidated Statements of Financial Condition June 30, 2005 and December 31, 2004 2 Consolidated Statements of Operations Three- and Six-month periods ended June 30, 2005 and 2004 3 Consolidated Statements of Cash Flows Six-month periods ended June 30, 2005 and 2004 4 Consolidated Statements of Shareholders' Equity Six-month periods ended June 30, 2005 and 2004 5 Notes to Interim Consolidated Financial Statements 6-18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 19-39 Item 3. Quantitative and Qualitative Disclosures about Market Risk 40 Item 4. Controls and Procedures 40 PART II - Other Information Item 2. Unregistered sales of equity securities and use of proceeds 41 Item 4. Submission of Matters to a Vote of Security Holders 41 Item 6. Exhibits 42 </TABLE> Any statements in this document that are not historical facts are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Words such as "expect," "believe," "intend," "estimate," "project," "may" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are predicated on management's beliefs and assumptions based on information known to Independent Bank Corporation's management as of the date of this document and do not purport to speak as of any other date. Forward-looking statements may include descriptions of plans and objectives of Independent Bank Corporation's management for future or past operations, products or services, and forecasts of our revenue, earnings or other measures of economic performance, including statements of profitability, business segments and subsidiaries, and estimates of credit quality trends. Such statements reflect the view of Independent Bank Corporation's management as of this date with respect to future events and are not guarantees of future performance; involve assumptions and are subject to substantial risks and uncertainties, such as the changes in Independent Bank Corporation's plans, objectives, expectations and intentions. Should one or more of these risks materialize or should underlying beliefs or assumptions prove incorrect, our actual results could differ materially from those discussed. Factors that could cause or contribute to such differences are changes in interest rates, changes in the accounting treatment of any particular item, the results of regulatory examinations, changes in industries where we have a concentration of loans, changes in the level of fee income, changes in general economic conditions and related credit and market conditions, and the impact of regulatory responses to any of the foregoing. Forward-looking statements speak only as of the date they are made. Independent Bank Corporation does not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made. For any forward-looking statements made in this document, Independent Bank Corporation claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.
Part I Item 1. INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition <TABLE> <CAPTION> June 30, December 31, 2005 2004 ------------- ------------ (unaudited) ----------------------------- (in thousands) <S> <C> <C> Assets Cash and due from banks $ 74,950 $ 72,815 Securities available for sale 530,182 550,908 Federal Home Loan Bank stock, at cost 17,322 17,322 Loans held for sale 40,856 38,756 Loans Commercial 964,410 931,251 Real estate mortgage 813,640 773,609 Installment 275,274 266,042 Finance receivables 346,371 254,388 ------------- ------------ Total Loans 2,399,695 2,225,290 Allowance for loan losses (25,720) (24,737) ------------- ------------ Net Loans 2,373,975 2,200,553 Property and equipment, net 59,150 56,569 Bank owned life insurance 38,676 38,337 Goodwill 53,835 53,354 Other intangibles 12,116 13,503 Accrued income and other assets 52,086 51,910 ------------- ------------ Total Assets $ 3,253,148 $ 3,094,027 ============= ============ Liabilities and Shareholders' Equity Deposits Non-interest bearing $ 294,613 $ 287,672 Savings and NOW 849,898 849,110 Time 1,209,462 1,040,165 ------------- ------------ Total Deposits 2,353,973 2,176,947 Federal funds purchased 143,815 117,552 Other borrowings 355,054 405,386 Subordinated debentures 64,197 64,197 Financed premiums payable 38,847 48,160 Accrued expenses and other liabilities 53,184 51,493 ------------- ------------ Total Liabilities 3,009,070 2,863,735 ------------- ------------ Shareholders' Equity Preferred stock, no par value -- 200,000 shares authorized; none outstanding Common stock, $1.00 par value -- 30,000,000 shares authorized; issued and outstanding: 21,180,292 shares at June 30, 2005 and 21,194,651 shares at December 31, 2004 21,180 21,195 Capital surplus 157,444 158,797 Retained earnings 57,148 41,795 Accumulated other comprehensive income 8,306 8,505 ------------- ------------ Total Shareholders' Equity 244,078 230,292 ------------- ------------ Total Liabilities and Shareholders' Equity $ 3,253,148 $ 3,094,027 ============= ============ </TABLE> See notes to interim consolidated financial statements 2
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations <TABLE> <CAPTION> Three Months Ended Six Months Ended June 30, June 30, 2005 2004 2005 2004 ----------- ------------ ------------ ----------- (unaudited) (unaudited) ------------------------- ------------------------- (in thousands, except per share amounts) <S> <C> <C> <C> <C> Interest Income Interest and fees on loans $ 43,985 $ 32,321 $ 85,170 $ 62,447 Securities available for sale Taxable 3,561 2,997 7,253 6,091 Tax-exempt 2,736 2,246 5,304 4,475 Other investments 123 168 335 334 ----------- ------------ ------------ ----------- Total Interest Income 50,405 37,732 98,062 73,347 ----------- ------------ ------------ ----------- Interest Expense Deposits 10,664 6,018 19,838 12,220 Other borrowings 5,307 3,966 10,269 8,004 ----------- ------------ ------------ ----------- Total Interest Expense 15,971 9,984 30,107 20,224 ----------- ------------ ------------ ----------- Net Interest Income 34,434 27,748 67,955 53,123 Provision for loan losses 2,528 709 4,134 1,510 ----------- ------------ ------------ ----------- Net Interest Income After Provision for Loan Losses 31,906 27,039 63,821 51,613 ----------- ------------ ------------ ----------- Non-interest Income Service charges on deposit accounts 4,958 4,258 9,000 7,899 Net gains on asset sales Real estate mortgage loans 1,307 2,163 2,695 3,222 Securities 1,283 2 1,251 495 Title insurance fees 468 539 965 1,083 Manufactured home loan origination fees 337 320 611 609 VISA check card interchange income 685 492 1,307 908 Real estate mortgage loan servicing 174 1,765 1,238 1,081 Other income 1,958 1,729 3,828 3,408 ----------- ------------ ------------ ----------- Total Non-interest Income 11,170 11,268 20,895 18,705 ----------- ------------ ------------ ----------- Non-interest Expense Compensation and employee benefits 13,177 11,854 26,656 22,953 Occupancy, net 2,103 1,814 4,341 3,637 Furniture and fixtures 1,715 1,475 3,513 2,865 Other expenses 9,011 11,084 17,522 17,430 ----------- ------------ ------------ ----------- Total Non-interest Expense 26,006 26,227 52,032 46,885 ----------- ------------ ------------ ----------- Income Before Income Tax 17,070 12,080 32,684 23,433 Income tax expense 4,944 3,097 9,257 6,007 ----------- ------------ ------------ ----------- Net Income $ 12,126 $ 8,983 $ 23,427 $ 17,426 =========== ============ ============ =========== Net Income Per Share Basic $ .57 $ .45 $ 1.10 $ .88 Diluted .56 .44 1.08 .86 Dividends Per Common Share Declared $ .19 .16 .38 .32 Paid .19 .16 .35 .32 </TABLE> See notes to interim consolidated financial statements 3
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows <TABLE> <CAPTION> Six months ended June 30, 2005 2004 ------------- ------------ (unaudited) ---------------------------- (in thousands) <S> <C> <C> Net Income $ 23,427 $ 17,426 ------------- ------------ Adjustments to Reconcile Net Income to Net Cash from Operating Activities Proceeds from sales of loans held for sale 186,568 209,852 Disbursements for loans held for sale (185,973) (210,657) Provision for loan losses 4,134 1,510 Depreciation and amortization of premiums and accretion of discounts on securities and loans (6,010) (343) Net gains on sales of real estate mortgage loans (2,695) (3,222) Net gains on securities (1,251) (495) Write-off of uncompleted software 977 Deferred loan fees (490) (400) Increase in accrued income and other assets (1,049) (2,665) Increase in accrued expenses and other liabilities 2,680 8,985 Increase (decrease) in financed premiums payable (9,313) 10,701 ------------- ------------ (13,399) 14,243 ------------- ------------ Net Cash from Operating Activities 10,028 31,669 ------------- ------------ Cash Flow used in Investing Activities Proceeds from the sale of securities available for sale 35,970 15,077 Proceeds from the maturity of securities available for sale 5,104 5,357 Principal payments received on securities available for sale 29,267 25,428 Purchases of securities available for sale (48,741) (59,187) Principal payments on portfolio loans purchased 998 2,687 Portfolio loans originated, net of principal payments (167,227) (124,890) Acquisition of business, less cash received (8,600) Capital expenditures (6,045) (6,509) ------------- ------------ Net Cash used in Investing Activities (150,674) (150,637) ------------- ------------ Cash Flow from Financing Activities Net increase in total deposits 177,026 65,162 Net increase in short-term borrowings 20,010 51,503 Proceeds from Federal Home Loan Bank advances 310,750 256,100 Payments of Federal Home Loan Bank advances (355,829) (229,515) Retirement of long term debt 1,000 Dividends paid (7,241) (5,901) Proceeds from issuance of common stock 1,138 2,662 Repurchase of common stock (4,073) (2,002) ------------- ------------ Net Cash from Financing Activities 142,781 138,009 ------------- ------------ Net Increase in Cash and Cash Equivalents 2,135 19,041 Cash and Cash Equivalents at Beginning of Period 72,815 61,741 ------------- ------------ Cash and Cash Equivalents at End of Period $ 74,950 $ 80,782 ============= ============ Cash paid during the period for Interest $ 27,786 $ 20,207 Income taxes 8,124 1,203 Transfer of loans to other real estate 2,071 1,674 </TABLE> See notes to interim consolidated financial statements 4
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity <TABLE> <CAPTION> Six months ended June 30, 2005 2004 ---------- ---------- (unaudited) ----------------------- (in thousands) <S> <C> <C> Balance at beginning of period $ 230,292 $ 162,216 Net income 23,427 17,426 Cash dividends declared (8,074) (6,473) Issuance of common stock 2,705 32,146 Repurchase of common stock (4,073) (2,002) Net change in accumulated other comprehensive income, net of related tax effect (note 4) (199) (3,079) ---------- ---------- Balance at end of period $ 244,078 $ 200,234 ========== ========== </TABLE> See notes to interim consolidated financial statements. 5
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. In our opinion, the accompanying unaudited consolidated financial statements contain all the adjustments necessary to present fairly our consolidated financial condition as of June 30, 2005 and December 31, 2004, and the results of operations for the three and six-month periods ended June 30, 2005 and 2004. Certain reclassifications have been made in the prior year financial statements to conform to the current year presentation. Our critical accounting policies include the assessment for other than temporary impairment on investment securities, the determination of the allowance for loan losses, the valuation of derivative financial instruments, the valuation of originated mortgage servicing rights, the valuation of deferred tax assets and the valuation of goodwill. Refer to our 2004 Annual Report on Form 10-K for a disclosure of our accounting policies. 2. Our assessment of the allowance for loan losses is based on an evaluation of the loan portfolio, recent loss experience, current economic conditions and other pertinent factors. Loans on non-accrual status, past due more than 90 days, or restructured amounted to $27.5 million at June 30, 2005, and $15.1 million at December 31, 2004. (See Management's Discussion and Analysis of Financial Condition and Results of Operations). 3. The provision for income taxes represents federal and state income tax expense calculated using annualized rates on taxable income generated during the respective periods. 4. Comprehensive income for the three- and six-month periods ended June 30 follows: <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 -------- -------- -------- -------- (in thousands) <S> <C> <C> <C> <C> Net income $ 12,126 $ 8,983 $ 23,427 $ 17,426 Net change in unrealized gain on securities available for sale, net of related tax effect 909 (9,911) (335) (5,990) Net change in unrealized gain (loss) on derivative instruments, net of related tax effect (1,474) 3,414 136 2,911 -------- -------- -------- -------- Comprehensive income $ 11,561 $ 2,486 $ 23,228 $ 14,347 ======== ======== ======== ======== </TABLE> The net change in unrealized gain on securities available for sale reflect net gains and losses reclassified into earnings as follows: <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 -------- -------- -------- -------- (in thousands) <S> <C> <C> <C> <C> Gain reclassified into earnings $ 1,283 $ 2 $ 1,251 $ 495 Federal income tax expense as a result of the reclassification of these amounts from comprehensive income 449 438 173 </TABLE> 5. Our reportable segments are based upon legal entities. We have five reportable segments: Independent Bank ("IB"), Independent Bank West Michigan ("IBWM"), Independent Bank South Michigan ("IBSM"), Independent Bank East Michigan ("IBEM") and Mepco Insurance Premium Financing, Inc. ("Mepco"). We evaluate performance based principally on net income of the respective reportable segments. 6
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) A summary of selected financial information for our reportable segments as of or for the three-month and six-month periods ended June 30, follows: As of or for the three months ended June 30, <TABLE> <CAPTION> IB IBWM IBSM IBEM Mepco Other(1) Elimination Total ---------- -------- --------- -------- -------- -------- ----------- ---------- (in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> 2005 Total assets $1,015,442 $705,836 $ 467,884 $689,545 $374,942 $331,466 $ 331,967 $3,253,148 Interest income 15,628 9,871 6,473 9,879 8,600 8 54 50,405 Net interest income 10,812 7,408 4,255 7,281 6,107 (1,415) 14 34,434 Provision for loan losses 1,076 745 218 302 187 2,528 Income (loss) before income tax 9,398 3,874 2,534 2,849 3,684 (319) 4,950 17,070 Net income (loss) 6,694 2,717 1,920 2,128 2,244 (268) 3,309 12,126 2004 Total assets $1,036,799 $476,847 $ 386,109 $661,253 $220,265 $278,605 $ 281,219 $2,778,659 Interest income 14,797 7,017 4,939 6,089 4,873 21 4 37,732 Net interest income 10,690 5,766 3,456 4,718 4,210 (1,092) 27,748 Provision for loan losses 359 64 142 160 (16) 709 Income (loss) before income tax 6,843 4,586 2,182 1,594 (1,642) (1,324) 159 12,080 Net income (loss) 4,982 3,201 1,600 1,282 (1,033) (890) 159 8,983 </TABLE> As of or for the six months ended June 30, <TABLE> <CAPTION> IB IBWM IBSM IBEM Mepco Other(1) Elimination Total ---------- -------- --------- -------- -------- -------- ----------- ---------- (in thousands) <S> <C> <C> <C> <C> <C> <C> <C> <C> 2005 Total assets $1,015,442 $705,836 $ 467,884 $689,545 $374,942 $331,466 $ 331,967 $3,253,148 Interest income 32,751 17,429 12,310 19,256 16,371 13 68 98,062 Net interest income 23,078 13,135 8,195 14,389 11,998 (2,826) 14 67,955 Provision for loan losses 714 839 1,498 620 463 4,134 Income (loss) before income tax 16,798 7,396 3,605 5,477 7,123 (2,613) 5,102 32,684 Net income (loss) 12,050 5,227 2,871 4,108 4,291 (1,659) 3,461 23,427 2004 Total assets $1,036,799 $476,847 $ 386,109 $661,253 $220,265 $278,605 $ 281,219 $2,778,659 Interest income 29,604 13,827 9,778 10,950 9,172 25 9 73,347 Net interest income 21,023 11,035 6,835 8,364 8,028 (2,162) 53,123 Provision for loan losses 712 212 246 200 140 1,510 Income (loss) before income tax 11,633 7,670 3,990 3,043 48 (2,597) 354 23,433 Net income (loss) 8,654 5,434 2,957 2,461 (1) (1,725) 354 17,426 </TABLE> (1) Includes items relating to the Registrant and certain insignificant operations. 7
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 6. Basic income per share is based on weighted average common shares outstanding during the period. Diluted income per share includes the dilutive effect of additional potential common shares to be issued upon the exercise of stock options and stock units for a deferred compensation plan for non-employee directors. A reconciliation of basic and diluted earnings per share for the three-month and the six-month periods ended June 30 follows: <TABLE> <CAPTION> Three months Six months ended ended June 30, June 30, 2005 2004 2005 2004 -------- -------- -------- -------- (in thousands, except per share amounts) <S> <C> <C> <C> <C> Net income $ 12,126 $ 8,983 $ 23,427 $ 17,426 ======== ======== ======== ======== Weighted-average shares outstanding 21,201 20,029 21,215 19,797 Effect of stock options 343 359 370 397 Stock units for deferred compensation plan for non- employee directors 45 44 46 45 -------- -------- -------- -------- Weighted-average shares outstanding for calculation of diluted earnings per share 21,589 20,432 21,631 20,239 ======== ======== ======== ======== Net income per share Basic $ .57 $ .45 $ 1.10 $ .88 Diluted .56 .44 1.08 .86 </TABLE> Weighted average stock options outstanding that were anti-dilutive totaled 0.2 million and 0.3 million for the three-months ended June 30, 2005 and 2004, respectively. During the six-month periods ended June 30, 2005 and 2004, weighted-average anti-dilutive stock options totaled 0.1 million and 0.2 million respectively. On July 19, 2005 the board of directors declared a 5% common stock dividend payable September 30, 2005 to shareholders of record on September 6, 2005. Per share data has not been restated for this dividend. 7. Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS #133") which was subsequently amended by SFAS #138, requires companies to record derivatives on the balance sheet as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting. 8
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) Our derivative financial instruments according to the type of hedge in which they are designated under SFAS #133 follows: <TABLE> <CAPTION> June 30, 2005 Average Notional Maturity Fair Amount (years) Value -------- -------- ------ (dollars in thousands) <S> <C> <C> <C> Fair Value Hedge - pay variable interest-rate swap agreements $275,659 3.7 $ (213) ======== === ====== Cash Flow Hedge - pay fixed interest-rate swap agreements $340,500 1.6 $1,549 ======== === ====== No hedge designation Pay fixed interest-rate swap agreements $ 10,000 0.5 $ 69 Pay variable interest-rate swap agreements 65,000 0.4 (127) Rate-lock real estate mortgage loan commitments 24,392 0.1 157 Mandatory commitments to sell real estate mortgage loans 64,801 0.1 (118) -------- --- ------ Total $164,193 0.2 $ (19) ======== === ====== </TABLE> We have established management objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. We monitor our interest rate risk position via simulation modeling reports (See "Asset/liability management"). The goal of our asset/liability management efforts is to maintain profitable financial leverage within established risk parameters. We use variable rate and short-term fixed-rate (less than 12 months) debt obligations to fund a portion of our balance sheet, which exposes us to variability in interest rates. To meet our objectives, we may periodically enter into derivative financial instruments to mitigate exposure to fluctuations in cash flows resulting from changes in interest rates ("Cash Flow Hedges"). Cash Flow Hedges currently include certain pay-fixed interest-rate swaps. Pay-fixed interest-rate swaps convert the variable-rate cash flows on debt obligations to fixed-rates. Under interest-rate collars, we will receive cash if interest rates rise above a predetermined level while we will make cash payments if interest rates fall below a predetermined level. As a result, we effectively have variable rate debt with an established maximum and minimum rate. We record the fair value of Cash Flow Hedges in accrued income and other assets and accrued expenses and other liabilities. On an ongoing basis, we adjust our balance sheet to reflect the then current fair value of Cash Flow Hedges. The related gains or losses are reported in other comprehensive income and are subsequently reclassified into earnings, as a yield adjustment in the same period in which the related interest on the hedged items (primarily variable-rate debt obligations) affect earnings. It is anticipated that approximately $0.9 million, net of tax, of unrealized gains on Cash Flow Hedges at June 30, 2005 will be reclassified to earnings over the next twelve months. To the extent that the Cash Flow Hedges are not effective, the ineffective portion of the Cash Flow Hedges are immediately recognized as interest expense. The maximum term of any Cash Flow Hedge at June 30, 2005 is 6.9 years. We also use long-term, fixed-rate brokered CDs to fund a portion of our balance sheet. These instruments expose us to variability in fair value due to changes in interest rates. To meet our objectives, we may enter into derivative financial instruments to mitigate exposure to fluctuations in fair values of such fixed-rate debt instruments ("Fair Value Hedges"). Fair Value Hedges currently include pay-variable interest rate swaps. 9
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) Also, we record Fair Value Hedges at fair value in accrued income and other assets and accrued expenses and other liabilities. The hedged items (primarily fixed-rate debt obligations) are also recorded at fair value through the statement of operations, which offsets the adjustment to Fair Value Hedges. On an ongoing basis, we will adjust our balance sheet to reflect the then current fair value of both the Fair Value Hedges and the respective hedged items. To the extent that the change in value of the Fair Value Hedges do not offset the change in the value of the hedged items, the ineffective portion is immediately recognized as interest expense. Certain derivative financial instruments are not designated as hedges. The fair value of these derivative financial instruments have been recorded on our balance sheet and are adjusted on an ongoing basis to reflect their then current fair value. The changes in the fair value of derivative financial instruments not designated as hedges, are recognized currently as interest expense. In the ordinary course of business, we enter into rate-lock real estate mortgage loan commitments with customers ("Rate Lock Commitments"). These commitments expose us to interest rate risk. We also enter into mandatory commitments to sell real estate mortgage loans ("Mandatory Commitments") to hedge price fluctuations of mortgage loans held for sale and Rate Lock Commitments. Mandatory Commitments help protect our loan sale profit margin from fluctuations in interest rates. The changes in the fair value of Rate Lock Commitments and Mandatory Commitments are recognized currently as part of gains on the sale of real estate mortgage loans. We utilize an outside third party to assist us in our valuation of Mandatory Commitments and Rate Lock Commitments. Interest expense and net gains on the sale of real estate mortgage loans, as well as net income may be more volatile as a result of derivative instruments, which are not designated as hedges. 10
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) The impact of SFAS #133 on net income and other comprehensive income for the three-month and six-month periods ended June 30, 2005 and 2004 is as follows: <TABLE> <CAPTION> Income (Expense) ------------------------------------------ Other Comprehensive Net Income Income Total ---------- ------------- ------- (in thousands) <S> <C> <C> <C> Change in fair value during the three- month period ended June 30, 2005 Interest-rate swap agreements not designated as hedges $ (18) $ (18) Rate Lock Commitments (281) (281) Mandatory Commitments (294) (294) Ineffectiveness of cash flow hedges 12 12 Cash flow hedges $ (2,299) (2,299) Reclassification adjustment 32 32 ---------- ------------- ------- Total (581) (2,267) (2,848) Income tax (203) (793) (996) ---------- ------------- ------- Net $ (378) $ (1,474) $(1,852) ========== ============= ======= </TABLE> <TABLE> <CAPTION> Income (Expense) ------------------------------------------ Other Comprehensive Net Income Income Total ---------- ------------- ------- (in thousands) <S> <C> <C> <C> Change in fair value during the six- month period ended June 30, 2005 Interest-rate swap agreements not designated as hedges $ (76) $ (76) Rate Lock Commitments 65 65 Mandatory Commitments (58) (58) Ineffectiveness of cash flow hedges 6 6 Cash flow hedges $ 477 477 Reclassification adjustment (267) (267) ---------- ------------- ------- Total (63) 210 147 Income tax (22) 74 52 ---------- ------------- ------- Net $ (41) $ 136 $ 95 ========== ============= ======= </TABLE> 11
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) <TABLE> <CAPTION> Income (Expense) ------------------------------------------ Other Comprehensive Net Income Income Total ---------- ------------- ------- (in thousands) <S> <C> <C> <C> Change in fair value during the three- month period ended June 30, 2004 Interest-rate swap agreements not designated as hedges $ 134 $ 134 Rate Lock Commitments 126 126 Mandatory Commitments (438) (438) Ineffectiveness of cash flow hedges (13) (13) Cash flow hedges $ 3,909 3,909 Reclassification adjustment 1,342 1,342 ---------- ------------- ------- Total (191) 5,251 5,060 Income tax (66) 1,837 1,771 ---------- ------------- ------- Net $ (125) $ 3,414 $ 3,289 ========== ============= ======= </TABLE> <TABLE> <CAPTION> Income (Expense) ------------------------------------------ Other Comprehensive Net Income Income Total ---------- ------------- ------- (in thousands) <S> <C> <C> <C> Change in fair value during the six- month period ended June 30, 2004 Interest-rate swap agreements not designated as hedges $ 86 $ 86 Rate Lock Commitments 178 178 Mandatory Commitments (275) (275) Ineffectiveness of cash flow hedges 2 2 Cash flow hedges $ 1,746 1,746 Reclassification adjustment 2,732 2,732 ---------- ------------- ------- Total (9) 4,478 4,469 Income tax (3) 1,567 1,564 ---------- ------------- ------- Net $ (6) $ 2,911 $ 2,905 ========== ============= ======= </TABLE> 12
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 8. Statement of Financial Accounting Standards No. 141, "Business Combinations," ("SFAS #141") and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," ("SFAS #142") effects how organizations account for business combinations and for the goodwill and intangible assets that arise from those combinations or are acquired otherwise. Intangible assets, net of amortization, were comprised of the following at June 30, 2005 and December 31, 2004: <TABLE> <CAPTION> June 30, 2005 December 31, 2004 ------------------------ ------------------------ Gross Gross Carrying Accumulated Carrying Accumulated Amount Amortization Amount Amortization -------- ------------ -------- ------------ (dollars in thousands) <S> <C> <C> <C> <C> Amortized intangible assets Core deposit $ 20,545 $ 10,697 $ 20,545 $ 9,685 Customer relationship 2,604 1,477 2,604 1,254 Covenants not to compete 1,520 379 1,520 227 -------- ------------ -------- ------------ Total $ 24,669 $ 12,553 $ 24,669 $ 11,166 ======== ============ ======== ============ Unamortized intangible assets - Goodwill $ 53,835 $ 53,354 ======== ============ </TABLE> Based on our review of goodwill recorded on the Statement of Financial Condition, no impairment existed as of June 30, 2005. Amortization of intangibles, has been estimated through 2010 and thereafter in the following table, and does not take into consideration any potential future acquisitions or branch purchases. <TABLE> <CAPTION> (dollars in thousands) ---------------------- <S> <C> Six months ended December 31, 2005 $ 1,387 Year ending December 31: 2006 2,572 2007 2,382 2008 2,061 2009 966 2010 and thereafter 2,748 ------------ Total $ 12,116 ============ </TABLE> 13
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) Changes in the carrying amount of goodwill and amortizing intangibles by reporting segment for the six months ended June 30, 2005 were as follows: <TABLE> <CAPTION> IB IBWM IBSM IBEM Mepco Other(1) Total -------- -------- ------- -------- ---------- -------- ------- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> Goodwill Balance, December 31, 2004 $ 9,702 $ 32 $ 23,205 $ 20,035 $ 380 $53,354 Goodwill adjustment during period (142)(2) 660(4) (37)(3) 481 -------- -------- ------- -------- ---------- -------- ------- Balance, June 30, 2005 $ 9,560 $ 32 $ 23,205 $ 20,695 $ 343 $53,835 ======== ======== ======= ======== ========== ======== ======= Core Deposit Intangible, net Balance, December 31, 2004 $ 2,540 $ 69 $ 467 $ 7,727 $ 57 $10,860 Amortization (237) (10) (72) (685) (8) (1,012) -------- -------- ------- -------- ---------- -------- ------- Balance, June 30, 2005 $ 2,303 $ 59 $ 395 $ 7,042 $ 49 $ 9,848 ======== ======== ======= ======== ========== ======== ======= Customer Relationship Intangible, net Balance, December 31, 2004 $ 1,350 $ 1,350 Amortization (223) (223) -------- -------- ------- -------- ---------- -------- ------- Balance, June 30, 2005 $ 1,127 $ 1,127 ======== ======== ======= ======== ========== ======== ======= Covenants not to compete, net Balance, December 31, 2004 $ 1,148 $ 145 $ 1,293 Amortization (130) (22) (152) -------- -------- ------- -------- ---------- -------- ------- Balance, June 30, 2005 $ 1,018 $ 123 $ 1,141 ======== ======== ======= ======== ========== ======== ======= </TABLE> (1) Includes items relating to the Registrant and certain insignificant operations. (2) Goodwill associated with the acquisition of North. See footnote #10. (3) Goodwill associated with the acquisition of Midwest. See footnote #10. (4) Goodwill associated with contingent consideration accrued pursuant to an earnout. 14
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 9. We maintain stock option plans for our non-employee directors as well as certain of our officers and those of our Banks and their subsidiaries. Options that were granted under these plans were granted with vesting periods of up to one year, at a price equal to the fair market value of the common stock on the date of grant, and expire not more than ten years after the date of grant. The per share weighted-average fair value of stock options was obtained using the Black-Scholes options pricing model. The following table summarizes the assumptions used and values obtained: <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ------ ------ ------ ------ <S> <C> <C> <C> <C> Expected dividend yield 2.75% 2.46% 2.57% 2.37% Risk-free interest rate 4.24 4.41 4.20 4.26 Expected life (in years) 9.76 9.75 9.73 9.65 Expected volatility 32.06% 32.23% 32.02% 32.54% Per share weighted-average fair value $ 9.76 $10.10 $ 9.73 $10.57 </TABLE> The following table summarizes the impact on our net income had compensation cost included the fair value of options at the grant date: <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, ------- ------- ------- ------- 2005 2004 2005 2004 (in thousands except per share amounts) <S> <C> <C> <C> <C> Net income - as reported $12,126 $ 8,983 $23,427 $17,426 Stock based compensation expense determined under fair value based method, net of related tax effect (964) (624) (1,626) (1,128) ------- ------- ------- ------- Pro-forma net income $11,162 $ 8,359 $21,801 $16,298 ======= ======= ======= ======= Income per share Basic As reported $ .57 $ .45 $ 1.10 $ .88 Pro-forma .53 .42 1.03 .82 Diluted As reported $ .56 $ .44 $ 1.08 $ .86 Pro-forma .52 .41 1.01 .81 </TABLE> 10. On May 31, 2004, we completed our acquisition of Midwest Guaranty Bancorp, Inc. ("Midwest") with the purpose of expanding our presence in southeastern Michigan. Midwest was a closely held bank holding company primarily doing business as a commercial bank. As a result of the closing of this transaction, we issued 997,700 shares of common stock and paid $16.6 million in cash to the Midwest shareholders. Our results include Midwest's operations subsequent to May 31, 2004. At the time of acquisition, Midwest had total assets of $238.0 million, total loans of $205.0 million, total deposits of $198.9 million and total stockholders' equity of $18.7 million. We recorded purchase accounting adjustments related to the Midwest acquisition including recording goodwill of $23.0 million, establishing a core deposit intangible of $4.9 million, and a covenant not to compete of $1.3 million. The core deposit intangible is being amortized on an accelerated basis over ten years and the covenant not to compete on a straight-line basis over five years. 15
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) The following is a condensed balance sheet of Midwest at our date of acquisition adjusted for updated information related to the fair value of assets acquired and liabilities assumed: <TABLE> <CAPTION> (in thousands) <S> <C> Cash and equivalents $ 8,390 Securities 19,557 Loans, net 201,476 Property and equipment 5,674 Intangible assets 6,219 Goodwill 23,037 Other assets 1,861 --------- Total assets acquired 266,214 --------- Deposits 199,123 Borrowings 12,314 Other liabilities 10,663 --------- Total liabilities assumed 222,100 --------- Net assets acquired $ 44,114 ========= </TABLE> On July 1, 2004, we completed our acquisition of North Bancorp, Inc. ("North"), with the purpose of expanding our presence in northern Michigan. North was a publicly held bank holding company primarily doing business as a commercial bank. As a result of the closing of this transaction, we issued 345,391 shares of common stock to the North shareholders. Our results include North's operations subsequent to July 1, 2004. At the time of acquisition, North had total assets of $155.1 million, total loans of $103.6 million, total deposits of $123.8 million and total stockholders' equity of $3.3 million. We recorded purchase accounting adjustments related to the North acquisition including recording goodwill of $2.8 million, and establishing a core deposit intangible of $2.2 million. The core deposit intangible is being amortized on an accelerated basis over eight years. The following is a condensed balance sheet of North at our date of acquisition adjusted for updated information related to the fair value of assets acquired and liabilities assumed: <TABLE> <CAPTION> (in thousands) <S> <C> Cash and equivalents $ 21,505 Securities 26,418 Loans, net 97,573 Property and equipment 2,318 Intangible assets 2,240 Goodwill 2,807 Other assets 9,440 --------- Total assets acquired 162,301 --------- Deposits 124,088 Borrowings 22,039 Other liabilities 7,401 --------- Total liabilities assumed 153,528 --------- Net assets acquired $ 8,773 ========= </TABLE> 16
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 11. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share Based Payment," ("SFAS #123R") which is a revision of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("SFAS #123"). SFAS #123R supersedes Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB #25") and amends Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," ("SFAS #95"). Generally the requirements of SFAS #123R are similar to the requirements described in SFAS #123. However, SFAS #123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure is no longer an alternative. Statement #123R originally was to be effective at the beginning of the first interim or annual period beginning after June 15, 2005. However, on April 21, 2005 the Securities and Exchange Commission issued an amendment to Rule 4-01(a) of Regulation S-X that delayed the effective date for SFAS #123R to the first interim or annual reporting period of the registrant's first fiscal year beginning on or after June 15, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued. We expect to adopt SFAS #123R on January 1, 2006. SFAS #123R permits companies to adopt its requirements using one of two methods. First, a "modified prospective" method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS #123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS #123 for all awards granted to employees prior to the effective date of SFAS #123R that remain unvested on the effective date. Second, a "modified retrospective" method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS #123 for purposes of pro forma disclosures either (a) all prior period presented or (b) prior interim periods of the year of adoption. We plan to adopt SFAS #123R using the modified prospective method described above. As permitted by SFAS #123, we currently account for share-based payments to employees using APB #25's intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R's fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of SFAS #123R cannot be predicted at this time because it will depend on the level and type of share-based payments granted in the future. However, had we adopted SFAS #123R in prior periods, the impact of that standard would have approximated the impact of SFAS #123 as described in the disclosure of pro forma net income and earnings per share in Note #9 to above. 17
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) In 2003, the Emerging Issues Task Force ("EITF") issued Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The recognition and measurement guidance in EITF 03-1 should be applied in other-than-temporary impairment evaluations performed in reporting periods beginning after June 15, 2004. Disclosures were effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under FASB Statement of Financial Accounting Standards No. 115, "Accounting in Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations". The disclosure requirements for all other investments are effective in annual financial statements for fiscal years ending after June 15, 2004. Comparative information for periods prior to initial application is not required. On September 15, 2004, the FASB staff proposed two FASB Staff Positions ("FSP"). The first, proposed FSP EITF Issue 03-1-a, "Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,'" would provide guidance for the application of paragraph 16 of EITF 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases. The second, proposed FSP EITF Issue 03-1-b, "Effective Date of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments," would delay the effective date of EITF 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. Other investments within the scope of EITF 03-1 remain subject to its recognition and measurement provisions for interim and annual periods beginning after June 15, 2004. The disclosure provisions of EITF 03-1 also were not affected by the two proposed FSPs. On June 29, 2005 the FASB staff was directed to issue proposed FSP EITF Issue 03-1-a. The final FSB will supercede EITF Issue No. 03-1 and EITF Topic No. D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." The final FSB (retitled FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments"), will replace the guidance set forth in paragraphs 10-18 of EITF Issue 03-1 with references to existing other-than-temporary impairment guidance. FSP 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later that when the impairment is deemed other than temporary, even if a decision to sell has not been made. FSP FAS 115-1 would be effective for other-than-temporary impairment analyses conducted in periods beginning after September 15, 2005. In December 2003, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 03-03, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer". This SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in purchase business combinations. This SOP does not apply to loans originated by us and is effective for loans acquired in fiscal years beginning after December 15, 2004. This SOP is expected to have a significant impact on our future acquisitions as it will require the allocation of the acquired entity's allowance for loan losses to individual loans. 12. The results of operations for the three- and six-month periods ended June 30, 2005, are not necessarily indicative of the results to be expected for the full year. 18
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following section presents additional information that may be necessary to assess our financial condition and results of operations. This section should be read in conjunction with our consolidated financial statements contained elsewhere in this report as well as our 2004 Annual Report on Form 10-K. 2005 results include the operations of Midwest, which was acquired on May 31, 2004, and North, which was acquired on July 1, 2004. Second quarter 2004 results only include the operations of Midwest subsequent to May 31, 2004. FINANCIAL CONDITION SUMMARY Our total assets increased $159.1 million during the first six months of 2005. Loans, excluding loans held for sale ("Portfolio Loans"), totaled $2.400 billion at June 30, 2005, an increase of $174.4 million from December 31, 2004. This was primarily due to growth in commercial loans, real estate mortgage loans and finance receivables. (See "Portfolio loans and asset quality.") Deposits totaled $2.354 billion at June 30, 2005, compared to $2.177 billion at December 31, 2004. The $177.0 million increase in total deposits during the period principally reflects an increase in time deposits. Other borrowings totaled $355.1 million at June 30, 2005, a decrease of $50.3 million from December 31, 2004. This was primarily attributable to the payoff of maturing borrowings with funds from brokered certificates of deposit ("Brokered CD's"). SECURITIES We maintain diversified securities portfolios, which may include obligations of the U.S. Treasury and government-sponsored agencies as well as securities issued by states and political subdivisions, corporate securities, mortgage-backed securities and asset-backed securities. We also invest in capital securities, which include preferred stocks and trust preferred securities. We regularly evaluate asset/liability management needs and attempt to maintain a portfolio structure that provides sufficient liquidity and cash flow. We believe that the unrealized losses on securities available for sale are temporary in nature and due primarily to changes in interest rates and are expected to be recovered within a reasonable time period. We also believe that we have the ability to hold securities with unrealized losses to maturity or until such time as the unrealized losses reverse. (See "Asset/liability management.") SECURITIES <TABLE> <CAPTION> Unrealized -------------------------- Amortized Fair Cost Gains Losses Value --------- ------- ------ -------- (in thousands) <S> <C> <C> <C> <C> Securities available for sale June 30, 2005 $ 518,952 $14,297 $3,067 $530,182 December 31, 2004 539,162 13,448 1,702 550,908 </TABLE> Securities available for sale declined modestly during the first six months of 2005 as strong loan growth supplanted the need for any significant purchases of new investment securities. Generally we cannot earn the same interest-rate spread on securities as we can on loans. As a 19
result, offsetting slow loan growth with purchases of securities will tend to erode some of our profitability measures, including our return on assets. At June 30, 2005 and December 31, 2004, we had $18.4 million and $23.6 million, respectively, of asset-backed securities included in securities available for sale. Approximately 97% of our asset-backed securities at June 30, 2005 are backed by mobile home loans (compared to 87% at December 31, 2004). All of our asset-backed securities are rated as investment grade (by the major rating agencies) except for one mobile home loan asset-backed security with a book value of $2.5 million at June 30, 2005 that was down graded during 2004 to a below investment grade rating. We did not record any impairment charge on this security in the second quarter of 2005 but during the first quarter of 2005 we recorded an impairment charge of $0.2 million due primarily to some further credit related deterioration on the underlying mobile home loan collateral (we also recorded impairment charges on this security totaling $0.2 million in 2004). We continue to closely monitor this particular security as well as our entire mobile home loan asset-backed securities portfolio. We do not foresee, at the present time, any significant risk of loss (related to credit issues) with respect to any of our other asset-backed securities. During the second quarter of 2005 we recorded an additional $0.1 million impairment charge on Fannie Mae and Freddie Mac preferred securities (we also recorded impairment charges on Fannie Mae and Freddie Mac preferred securities of $0.1 million and $1.4 million during the first quarter of 2005 and during all of 2004, respectively). At June 30, 2005, we had a remaining book balance of $26.4 million in Fannie Mae and Freddie Mac preferred securities. The FASB is considering certain clarifications related to the assessment of other than temporary impairment on investment securities as well as other related accounting matters (See note #11 of Notes to Interim Consolidated Financial Statements). Sales of securities available for sale were as follows (See "Non-interest income."): <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ------- ------- ------- ------- (in thousands) <S> <C> <C> <C> <C> Proceeds $28,094 $ 1,965 $35,970 $15,077 ======= ======= ======= ======= Gross gains $ 1,533 $ 3 $ 2,032 $ 622 Gross losses 119 1 398 127 Impairment charges 131 383 ------- ------- Net Gains $ 1,283 $ 2 $ 1,251 $ 495 ======= ======= ======= ======= </TABLE> PORTFOLIO LOANS AND ASSET QUALITY We believe that our decentralized loan origination structure provides important advantages in serving the credit needs of our principal lending markets. In addition to the communities served by our bank branch networks, principal lending markets include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also participate in commercial lending transactions with certain non-affiliated banks and may also purchase real estate mortgage loans from third-party originators. Our April 2003 acquisition of Mepco added the financing of insurance premiums and extended automobile warranties to our lending activities. These are relatively new lines of business for us and expose us to new risks. Mepco conducts its lending activities across the United States. Mepco generally does not evaluate the creditworthiness of the individual borrower but instead primarily relies on the loan collateral (the unearned insurance premium or automobile warranty contract) in the event of default. As a result, we have established and monitor insurance carrier concentration limits in order to manage our collateral exposure. The insurance carrier 20
concentration limits are primarily based on the insurance company's AM Best rating and statutory surplus level. Mepco also has established procedures for loan servicing and collections, including the timely cancellation of the insurance policy or automobile warranty contract in order to protect our collateral position in the event of default. Mepco also has established procedures to attempt to prevent and detect fraud since the loan origination activities and initial borrower contact is entirely done through unrelated third parties (primarily insurance agents and automobile warranty administrators or automobile dealerships). There can be no assurance that the aforementioned risk management policies and procedures will prevent us from the possibility of incurring significant credit or fraud related losses in this business segment. Although the management and board of directors of each of our banks retain authority and responsibility for credit decisions, we have adopted uniform underwriting standards. Further, our loan committee structure as well as the centralization of commercial loan credit services and the loan review process, provides requisite controls and promotes compliance with such established underwriting standards. Such centralized functions also facilitate compliance with consumer protection laws and regulations. There can be no assurance that the aforementioned centralization of certain lending procedures and the use of uniform underwriting standards will prevent us from the possibility of incurring significant credit losses in our lending activities. We generally retain loans that may be profitably funded within established risk parameters. (See "Asset/liability management.") As a result, we may hold adjustable-rate and balloon real estate mortgage loans as Portfolio Loans, while 15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure to changes in interest rates. (See "Non-interest income.") During the first six months of 2005 our balance of real estate mortgage loans held in portfolio increased by $40.0 million. The $33.2 million increase in commercial loans during the six months ended June 30, 2005, principally reflects our emphasis on lending opportunities within this category of loans and an increase in commercial lending staff. Loans secured by real estate comprise the majority of new commercial loans. The $346.4 million of finance receivables at June 30, 2005 are comprised principally of loans to businesses to finance insurance premiums and payment plans offered to individuals to finance extended automobile warranties. The growth in this category of loans is primarily due to the geographic expansion of Mepco's lending activities and the addition of sales staff to call on insurance agencies and automobile warranty administrators. Future growth of overall Portfolio Loans is dependent upon a number of competitive and economic factors. Declines in Portfolio Loans or competition leading to lower relative pricing on new Portfolio Loans could adversely impact our future operating results. We continue to view loan growth consistent with prevailing quality standards as a major short and long-term challenge. 21
NON-PERFORMING ASSETS <TABLE> <CAPTION> June 30, December 31, 2005 2004 --------- ------------ (dollars in thousands) <S> <C> <C> Non-accrual loans $ 20,539 $ 11,804 Loans 90 days or more past due and still accruing interest 6,725 3,123 Restructured loans 221 218 --------- ------------ Total non-performing loans 27,485 15,145 Other real estate and repossessed assets 2,985 2,113 --------- ------------ Total non-performing assets $ 30,470 $ 17,258 ========= ============ As a percent of Portfolio Loans Non-performing loans 1.15% 0.68% Allowance for loan losses 1.07 1.11 Non-performing assets to total assets 0.94 0.56 Allowance for loan losses as a percent of non-performing loans 94 163 </TABLE> The increase in the overall level of non-performing loans in the first six months of 2005 is primarily due to increases in non-performing commercial and real estate mortgage loans and finance receivables. The increase in non-performing commercial loans (to $15.9 million at June 30, 2005 from $6.5 million at December 31, 2004) is due primarily to the addition of four commercial credits with balances totaling approximately $8.0 million. One of these loans, with a balance of approximately $0.8 million, was brought current by the borrower subsequent to June 30, 2005. Two of these commercial credits (with balances totaling $6.2 million) are secured by low/moderate income apartment complexes located in the Saginaw, Michigan area. Although these two loans are seasoned credits (one loan was originated in 1996 and the other in 1999), over the past few years the occupancy rates in these complexes declined resulting in insufficient debt service coverage. We are negotiating a forbearance agreement with the borrower on these two credits and recently the occupancy rates in both apartment complexes have been increasing (although debt service coverage ratios remain inadequate). Both loans were placed on non-accrual in the second quarter of 2005 which resulted in a reversal of approximately $0.3 million in previously accrued interest income. New appraisals were just obtained on these apartment complexes. Based on an updated impairment analysis, additional specific allowances for losses were recorded at June 30, 2005 totaling $1.1 million (bringing the total specific allowances on these two credits to $1.3 million). The fourth commercial credit referred to above is a $1.0 million loan to a contractor. The loan has become past due primarily as a result of a slow down in the borrower's business. At the present time we believe this loan is adequately collateralized and therefore do not anticipate any significant loss will be incurred in relation to this credit. We believe that the increase in non-performing real estate mortgage loans (to $6.2 million at June 30, 2005 from $4.6 million at December 31, 2004) to some degree reflects weakened economic conditions in the State of Michigan which currently has one of the highest unemployment rates in the United States. The increase in non-performing finance receivables (to $3.5 million at June 30, 2005 from $2.1 million at December 31, 2004) is due primarily to the growth of this loan portfolio and the timing of the receipt of return premiums from insurance carriers. Other real estate and repossessed assets totaled $3.0 million and $2.1 million at June 30, 2005 and December 31, 2004, respectively. This increase is primarily a result of a rise in the level of residential homes acquired through foreclosure. 22
We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable. The ratio of net charge-offs to average loans was 0.28% on an annualized basis in the first half of 2005 compared to 0.17% in the first half of 2004. The increase in net charge-offs is primarily due to increases in the level of net charge-offs in all loan portfolio categories. Impaired loans totaled approximately $20.3 million and $15.0 million at June 30, 2005 and 2004, respectively. At those same dates, certain impaired loans with balances of approximately $17.9 million and $9.2 million, respectively had specific allocations of the allowance for loan losses, which totaled approximately $4.5 million and $2.1 million, respectively. Our average investment in impaired loans was approximately $16.7 million and $14.4 million for the six-month periods ended June 30, 2005 and 2004, respectively. Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance. Interest recognized on impaired loans during the first six months of 2005 was approximately $0.2 million compared to $0.3 million in the first six months of 2004. ALLOWANCE FOR LOSSES ON LOANS AND UNFUNDED COMMITMENTS <TABLE> <CAPTION> Six months ended June 30, 2005 2004 ----------------------- ----------------------- Unfunded Unfunded Loans Commitments Loans Commitments ------- ----------- ------- ----------- (in thousands) <S> <C> <C> <C> <C> Balance at beginning of period $24,737 $1,846 $16,836 $ 892 Additions (deduction) Allowance on loans acquired 3,576 Provision charged to operating expense 4,240 (106) 1,222 288 Recoveries credited to allowance 842 610 Loans charged against the allowance (4,099) (2,140) ------- ------ ------- ------ Balance at end of period $25,720 $1,740 $20,104 $1,180 ======= ====== ======= ====== Net loans charged against the allowance to average Portfolio Loans (annualized) 0.28% 0.17% </TABLE> In determining the allowance and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and/or the general terms of the loan portfolios. The allowance for losses on unfunded commitments is determined in a similar manner to the allowance for loan losses. The first element reflects our estimate of probable losses based upon our systematic review of specific loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, and discounted collateral exposure. The second element reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan 23
classification category that is based upon a historical analysis of losses incurred. The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third element is determined by assigning allocations based principally upon the ten-year average of loss experience for each type of loan. Recent years are weighted more heavily in this average. Average losses may be further adjusted based on the current delinquency rate. Loss analyses are conducted at least annually. The fourth element is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining the unallocated portion, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the loan portfolios. (See "Provision for credit losses.") Mepco's allowance for loan losses is determined in a similar manner as discussed above and takes into account delinquency levels, net charge-offs, unsecured exposure and other subjective factors deemed relevant to their lending activities. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES <TABLE> <CAPTION> June 30, December 31, 2005 2004 -------- ------------ (in thousands) <S> <C> <C> Specific allocations $ 4,513 $ 2,874 Other adversely rated loans 8,232 9,395 Historical loss allocations 6,594 6,092 Additional allocations based on subjective factors 6,381 6,376 -------- ------- $ 25,720 $24,737 -------- ------- </TABLE> DEPOSITS AND BORROWINGS Our competitive position within many of the markets served by our bank branch networks limits the ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits. Accordingly, we compete principally on the basis of convenience and personal service, while employing pricing tactics that are intended to enhance the value of core deposits. To attract new core deposits, we have implemented a high-performance checking program that utilizes a combination of direct mail solicitations, in-branch merchandising, gifts for customers opening new checking accounts or referring business to our banks and branch staff sales training. This program has generated increases in customer relationships as well as deposit service charges. We believe that the new relationships that result from these marketing and sales efforts provide valuable opportunities to cross sell related financial products and services. We have implemented strategies that incorporate federal funds purchased, other borrowings and Brokered CDs to fund a portion of our increases in interest earning assets. The use of such alternate sources of funds supplements our core deposits and is also an integral part of our asset/liability management efforts. 24
ALTERNATE SOURCES OF FUNDS <TABLE> <CAPTION> June 30, December 31, 2005 2004 ------------------------------- --------------------------------- Average Average Amount Maturity Rate Amount Maturity Rate ---------- --------- ---- ---------- --------- ---- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Brokered CDs(1) $ 759,486 2.0 years 3.11% $ 576,944 1.9 years 2.56% Fixed rate FHLB advances(1,2) 55,823 6.2 years 5.60 59,902 6.4 years 5.55 Variable rate FHLB advances(1) 123,000 0.4 years 3.46 164,000 0.4 years 2.32 Securities sold under agreements to Repurchase(1) 165,032 0.1 years 3.25 169,810 0.2 years 2.27 Federal funds purchased 143,815 1 day 3.48 117,552 1 day 2.44 ---------- --------- ---- ---------- --------- ---- Total $1,247,156 1.5 years 3.32% $1,088,208 1.4 years 2.63% ========== ========= ==== ========== ========= ==== </TABLE> - ---------- (1) Certain of these items have had their average maturity and rate altered through the use of derivative instruments, including pay-fixed and pay-variable interest rate swaps. (2) Advances totaling $10.0 million at both June 30, 2005 and December 31, 2004, respectively, have provisions that allow the FHLB to convert fixed-rate advances to adjustable rates prior to stated maturity. Other borrowings, principally advances from the Federal Home Loan Bank (the "FHLB") and securities sold under agreements to repurchase ("Repurchase Agreements"), totaled $355.1 million at June 30, 2005, compared to $405.4 million at December 31, 2004. The $50.3 million decrease in other borrowed funds principally reflects the payoff of maturing variable rate FHLB advances with funds from Brokered CD's. Derivative financial instruments are employed to manage our exposure to changes in interest rates. (See "Asset/liability management".) At June 30, 2005, we employed interest-rate swaps with an aggregate notional amount of $691.2 million. (See note #7 of Notes to Interim Consolidated Financial Statements.) LIQUIDITY AND CAPITAL RESOURCES Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for growing our investment and loan portfolios as well as to be able to respond to unforeseen liquidity needs. Our sources of funds include a stable deposit base, secured advances from the Federal Home Loan Bank of Indianapolis, both secured and unsecured federal funds purchased borrowing facilities with other commercial banks, an unsecured holding company credit facility and access to the capital markets (for trust preferred securities and Brokered CD's). At June 30, 2005 we had $681.5 million of time deposits that mature in the next twelve months. Historically, a majority of these maturing time deposits are renewed by our customers or are Brokered CD's that we expect to replace. Additionally $1.145 billion of our deposits at June 30, 2005 were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown over time as a result of our marketing and promotional activities. There can be no assurance that historical patterns of renewing time deposits or overall growth in deposits will continue in the future. We have developed contingency funding plans that stress tests our liquidity needs that may arise from certain events such as an adverse credit event, rapid loan growth or a disaster recovery situation. Our liquidity management also includes periodic monitoring of each bank that 25
segregates assets between liquid and illiquid and classifies liabilities as core and non-core. This analysis compares our total level of illiquid assets to our core funding. It is our goal to have core funding sufficient to finance illiquid assets. Over the past several years our Portfolio Loans have grown more rapidly than our core deposits. In addition much of this growth has been in loan categories that cannot generally be used as collateral for FHLB advances (such as commercial loans and finance receivables). As a result, we have become more dependent on wholesale funding sources (such as brokered CD's and Repurchase Agreements). In order to reduce this greater reliance on wholesale funding we intend to explore the potential securitization of both commercial loans and finance receivables during 2005. It is likely that a securitization facility would have a higher total cost than our current wholesale funding sources, which would adversely impact our future net interest income. However, we believe that the improved liquidity will likely outweigh the adverse impact on our net interest income. Effective management of capital resources is critical to our mission to create value for our shareholders. The cost of capital is an important factor in creating shareholder value and, accordingly, our capital structure includes unsecured debt and cumulative trust preferred securities. We also believe that a diversified portfolio of quality loans will provide superior risk-adjusted returns. Accordingly, we have implemented balance sheet management strategies that combine efforts to originate Portfolio Loans with disciplined funding strategies. Acquisitions have also been an integral component of our capital management strategies. (See "Acquisitions.") In March 2003, a special purpose entity, IBC Capital Finance II (the "trust") issued $1.6 million of common securities to Independent Bank Corporation and $50.6 million of trust preferred securities to the public. Independent Bank Corporation issued $52.2 million of subordinated debentures to the trust in exchange for the proceeds from the public offering. These subordinated debentures represent the sole asset of the trust. Both the common securities and subordinated debentures are included in our Consolidated Statements of Financial Condition at June 30, 2005, and December 31, 2004. In connection with our acquisition of Midwest, we assumed all of the duties, warranties and obligations of Midwest as the sponsor and sole holder of the common securities of Midwest Guaranty Trust I ("MGT"). In 2002, MGT, a special purpose entity, issued $0.2 million of common securities to Midwest and $7.5 million of trust preferred securities as part of a pooled offering. Midwest issued $7.7 million of subordinated debentures to the trust in exchange for the proceeds of the offering, which debentures represent the sole asset of MGT. Both the common securities and subordinated debentures are included in our Consolidated Statements of Financial Condition at June 30, 2005, and December 31, 2004. In connection with our acquisition of North, we assumed all of the duties, warranties and obligations of North as the sole general partner of Gaylord Partners, Limited Partnership ("GPLP"), a special purpose entity. In 2002, North contributed an aggregate of $0.1 million to the capital of GPLP and GPLP issued $5.0 million of floating rate cumulative preferred securities as part of a private placement offering. North issued $5.1 million of subordinated debentures to GPLP in exchange for the proceeds of the offering, which debentures represent the sole asset of GPLP. Independent Bank purchased $0.8 million of the GPLP floating rate cumulative preferred securities during the private placement offering. This investment security at Independent Bank and a corresponding amount of subordinated debentures are eliminated in consolidation. The remaining subordinated debentures as well as our capital investment in GPLP are included in our Consolidated Statements of Financial Condition at June 30, 2005 and December 31, 2004. 26
In March 2005, the Federal Reserve Board issued a final rule that retains trust preferred securities in the Tier 1 capital of bank holding companies. After a transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements will be limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of trust preferred securities and certain other elements in excess of the limit could be included in the Tier 2 capital, subject to restrictions. Based upon our existing levels of Tier 1 capital, trust preferred securities and goodwill, this final Federal Reserve Board rule would have reduced our Tier 1 capital to average assets ratio by approximately 19 basis points at June 30, 2005, (this calculation assumes no transition period). To supplement our balance sheet and capital management activities, we periodically repurchase our common stock. The level of share repurchases in a given year generally reflects changes in our need for capital associated with our balance sheet growth. In February 2005 we announced that our board of directors had authorized the repurchase of up to 0.8 million shares. This authorization expires on December 31, 2005. During the first six months of 2005 we repurchased 0.2 million shares at a weighted average price of $27.17 per share. CAPITALIZATION <TABLE> <CAPTION> June 30, December 31, 2005 2004 -------- ------------ (in thousands) <S> <C> <C> Unsecured debt $ 8,000 $ 9,000 -------- -------- Subordinated debentures 64,197 64,197 Amount not qualifying as regulatory capital (1,847) (1,847) -------- -------- Amount qualifying as regulatory capital 62,350 62,350 -------- -------- Shareholders' Equity Preferred stock, no par value Common stock, par value $1.00 per share 21,180 21,195 Capital surplus 157,444 158,797 Retained earnings 57,148 41,795 Accumulated other comprehensive income 8,306 8,505 -------- -------- Total shareholders' equity 244,078 230,292 -------- -------- Total capitalization $314,428 $301,642 ======== ======== </TABLE> Total shareholders' equity at June 30, 2005 increased $13.8 million from December 31, 2004, due primarily to the retention of earnings and the issuance of common stock pursuant to certain compensation plans, partially offset by cash dividends that we declared and a small decrease in accumulated other comprehensive income. Shareholders' equity totaled $244.1 million, equal to 7.50% of total assets at June 30, 2005. At December 31, 2004, shareholders' equity totaled $230.3 million, which was equal to 7.44% of assets. CAPITAL RATIOS <TABLE> <CAPTION> June 30, 2005 December 31, 2004 ------------- ----------------- <S> <C> <C> Equity capital 7.50% 7.44% Tier 1 leverage (tangible equity capital) 7.40 7.36 Tier 1 risk-based capital 9.40 9.39 Total risk-based capital 10.51 10.53 </TABLE> ASSET/LIABILITY MANAGEMENT Interest-rate risk is created by differences in the cash flow characteristics of our assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers' rights to prepay fixed-rate loans also create interest-rate risk. 27
Our asset/liability management efforts identify and evaluate opportunities to structure the balance sheet in a manner that is consistent with our mission to maintain profitable financial leverage within established risk parameters. We evaluate various opportunities and alternate balance-sheet strategies carefully and consider the likely impact on our risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of our balance-sheet management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. We have established parameters for interest-rate risk. We regularly monitor our interest-rate risk and report quarterly to our respective banks' boards of directors. We employ simulation analyses to monitor each bank's interest-rate risk profiles and evaluate potential changes in each banks' net interest income and market value of portfolio equity that result from changes in interest rates. The purpose of these simulations is to identify sources of interest-rate risk inherent in our balance sheets. The simulations do not anticipate any actions that we might initiate in response to changes in interest rates and, accordingly, the simulations do not provide a reliable forecast of anticipated results. The simulations are predicated on immediate, permanent and parallel shifts in interest rates and generally assume that current loan and deposit pricing relationships remain constant. The simulations further incorporate assumptions relating to changes in customer behavior, including changes in prepayment rates on certain assets and liabilities. RESULTS OF OPERATIONS SUMMARY Net income totaled $12.1 million and $23.4 million during the three- and six-month periods ended June 30, 2005. The increases in net income from the comparative periods in 2004 are primarily a result of increases in net interest income, service charges on deposits and securities gains. Partially offsetting these items were increases in the provision for loan losses and income tax expense and a decrease in gains on the sale of real estate mortgage loans. We believe that our earnings per share growth rate over a long period of time (five years or longer) is the best single measure of our performance. We strive to achieve an average annual long term earnings per share growth rate of approximately 10% to 15%. Consequently, we emphasize long-term performance over short-term results. Certain components of our revenues are cyclical in nature (such as mortgage-banking) which can cause fluctuations in our earnings per share from one period to another. Our primary strategies for achieving long-term growth in earnings per share include: earning asset growth (both organic and through acquisitions), diversification of revenues (within the financial services industry), effective capital management (efficient use of our shareholders' equity) and sound risk management (credit, interest rate, liquidity and regulatory risks). KEY PERFORMANCE RATIOS <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ----- ----- ----- ----- <S> <C> <C> <C> <C> Net income to Average assets 1.52% 1.43% 1.49% 1.43% Average equity 19.84 19.89 19.61 20.10 Earnings per common share Basic $0.57 $0.45 $1.10 $0.88 Diluted 0.56 0.44 1.08 0.86 </TABLE> 28
NET INTEREST INCOME Net interest income is the most important source of our earnings and thus is critical in evaluating our results of operations. Changes in our tax equivalent net interest income are primarily influenced by our level of interest-earning assets and the income or yield that we earn on those assets and the manner by which we fund (and the related cost of funding) such interest-earning assets. Certain macro-economic factors can also influence our net interest income such as the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in which we are doing business. Finally, risk management plays an important role in our level of net interest income. The ineffective management of credit risk and interest-rate risk in particular can adversely impact our net interest income. Tax equivalent net interest income increased by 24.0% to $36.1 million and by 27.4% to $71.1 million, respectively, during the three- and six-month periods in 2005 compared to 2004. These increases reflect an increase in average interest-earning assets that was partially offset by a decrease in tax equivalent net interest income as a percent of average interest-earning assets ("Net Yield"). We review yields on certain asset categories and our net interest margin on a fully taxable equivalent basis. This presentation is not in accordance with generally accepted accounting principles ("GAAP") but is customary in the banking industry. In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources. The adjustments to determine tax equivalent net interest income were $1.6 million and $1.3 million for the second quarters of 2005 and 2004, respectively, and were $3.1 million and $2.7 million for the first six months of 2005 and 2004, respectively. These adjustments were computed using a 35% tax rate. Average interest-earning assets totaled $2.952 billion and $2.912 billion during the three- and six-month periods in 2005, respectively. The increases from the corresponding periods of 2004 principally reflect increases in securities available for sale, commercial loans, real estate mortgage loans, finance receivables and the Midwest and North acquisitions. Our Net Yield decreased by 11 basis points to 4.89% during the three-month period in 2005 and also by 4 basis points to 4.91% during the six-month period in 2005 as compared to the like periods in 2004. These declines primarily reflect a flattening yield curve as short-term interest rates have increased significantly over the past twelve months while long-term interest rates have remained relatively unchanged. Our yields on interest-earning assets have increased in 2005 compared to 2004 which primarily reflects the aforementioned rise in short-term interest rates that has resulted in variable rate loans re-pricing at higher rates. However, the increases in the yields on average interest-earning assets were more than offset by rises in our interest expense as a percentage of average interest-earning assets (the "cost of funds"). The increase in our cost of funds also primarily reflects the rise in short-term interest rates that has resulted in higher rates on certain short-term and variable rate borrowings and higher rates on deposits. 29
AVERAGE BALANCES AND TAX EQUIVALENT RATES <TABLE> <CAPTION> Three Months Ended June 30, 2005 2004 ---------------------------------- --------------------------------- Average Average Balance Interest Rate Balance Interest Rate ------------- ----------- ---- ------------- --------- ---- <S> <C> <C> <C> <C> <C> <C> Assets (dollars in thousands) Taxable loans (1) $ 2,385,097 $ 43,909 7.38% $ 1,856,632 $ 32,241 6.97% Tax-exempt loans (1,2) 6,297 116 7.39 6,613 123 7.48 Taxable securities 287,792 3,561 4.96 257,863 2,997 4.67 Tax-exempt securities (2) 255,307 4,316 6.78 197,137 3,542 7.23 Other investments 17,371 123 2.84 14,297 168 4.73 ------------- ----------- ------------- --------- Interest Earning Assets 2,951,864 52,025 7.06 2,332,542 39,071 6.72 ----------- --------- Cash and due from banks 60,411 46,971 Other assets, net 192,126 142,423 ------------- ------------- Total Assets $ 3,204,401 $ 2,521,936 ============= ============= Liabilities Savings and NOW $ 878,836 1,867 0.85 $ 766,668 995 0.52 Time deposits 1,180,878 8,797 2.99 796,345 5,023 2.54 Long-term debt 6,495 74 4.57 2,637 13 1.98 Other borrowings 527,237 5,233 3.98 490,974 3,953 3.24 ------------- ----------- ------------- --------- Interest Bearing Liabilities 2,593,446 15,971 2.47 2,056,624 9,984 1.95 ----------- --------- Demand deposits 274,610 215,975 Other liabilities 91,157 67,685 Shareholders' equity 245,188 181,652 ------------- ------------- Total liabilities and shareholders' equity $ 3,204,401 $ 2,521,936 ============= ============= Tax Equivalent Net Interest Income $ 36,054 $ 29,087 =========== ========= Tax Equivalent Net Interest Income as a Percent of Earning Assets 4.89% 5.00% ==== ==== </TABLE> (1) All domestic (2) Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 35% 30
AVERAGE BALANCES AND TAX EQUIVALENT RATES <TABLE> <CAPTION> Six Months Ended June 30, 2005 2004 ------------------------------------ ------------------------------ Average Average Balance Interest Rate Balance Interest Rate ------------- ------------ ---- ----------- --------- ---- Assets (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Taxable loans (1) $ 2,341,439 $ 85,015 7.30% $ 1,788,570 $ 62,284 6.99% Tax-exempt loans (1,2) 7,168 238 6.70 6,740 251 7.49 Taxable securities 295,994 7,253 4.94 255,514 6,091 4.79 Tax-exempt securities (2) 249,850 8,342 6.73 198,021 7,069 7.18 Other investments 17,376 335 3.89 14,119 334 4.76 ------------- ------------ ----------- --------- Interest Earning Assets 2,911,827 101,183 6.99 2,262,964 76,029 6.75 ------------ --------- Cash and due from banks 60,545 45,554 Other assets, net 190,418 135,691 ------------- ----------- Total Assets $ 3,162,790 $ 2,444,209 ============= =========== Liabilities Savings and NOW $ 880,137 3,541 0.81 $ 743,366 1,967 0.53 Time deposits 1,137,242 16,297 2.89 794,265 10,253 2.60 Long-term debt 6,743 154 4.61 1,319 13 1.98 Other borrowings 534,398 10,115 3.82 464,556 7,991 3.46 ------------- ------------ ----------- --------- Interest Bearing Liabilities 2,558,520 30,107 2.37 2,003,506 20,224 2.03 ------------ --------- Demand deposits 273,612 199,183 Other liabilities 89,765 67,214 Shareholders' equity 240,893 174,306 ------------- ----------- Total liabilities and shareholders' equity $ 3,162,790 $ 2,444,209 ============= =========== Tax Equivalent Net Interest Income $ 71,076 $ 55,805 ============ ========= Tax Equivalent Net Interest Income as a Percent of Earning Assets 4.91% 4.95% ==== ==== </TABLE> (1) All domestic (2) Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 35% PROVISION FOR LOAN LOSSES The provision for loan losses was $2.5 million and $0.7 million during the three months ended June 30, 2005 and 2004, respectively. During the six-month periods ended June 30, 2005 and 2004, the provision was $4.1 million and $1.5 million, respectively. The increases in the provision reflect our assessment of the allowance for loan losses and the allowance for losses on unfunded commitments taking into consideration factors such as loan mix, levels of non-performing and classified loans and net charge-offs. (See "Portfolio loans and asset quality.") NON-INTEREST INCOME Non-interest income is a significant element in assessing our results of operations. On a long-term basis we are attempting to grow non-interest income in order to diversify our revenues within the financial services industry. We regard net gains on real estate mortgage loan sales as a core recurring source of revenue but they are quite cyclical and volatile. We regard net gains (losses) on securities as a "non-operating" component of non-interest income. As a result, we believe it is best to evaluate our success in growing non-interest income and diversifying our revenues by also comparing non-interest income when excluding net gains (losses) on assets (real estate mortgage loans and securities). 31
Non-interest income totaled $11.2 million during the three months ended June 30, 2005, a $0.1 million decrease from the comparable period in 2004. This decrease was primarily due to declines in net gains on the sale of real estate mortgage loans and real estate mortgage loan servicing income that were substantially offset by increases in service charges on deposit accounts and securities gains. Non-interest income increased to $20.9 million during the six months ended June 30, 2005, from $18.7 million a year earlier due primarily to increases in service charges on deposits, securities gains and VISA check card interchange income, partially offset by a decline in gains on the sale of real estate mortgage loans. NON-INTEREST INCOME <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ------- ------- ------- ------- (in thousands) <S> <C> <C> <C> <C> Service charges on deposit accounts $ 4,958 $ 4,258 $ 9,000 $ 7,899 Net gains (losses) on asset sales Real estate mortgage loans 1,307 2,163 2,695 3,222 Securities 1,283 2 1,251 495 Title insurance fees 468 539 965 1,083 VISA check card interchange income 685 492 1,307 908 Bank owned life insurance 368 383 757 728 Manufactured home loan origination fees and commissions 337 320 611 609 Mutual fund and annuity commissions 405 296 697 643 Real estate mortgage loan servicing 174 1,765 1,238 1,081 Other 1,185 1,050 2,374 2,037 ------- ------- ------- ------- Total non-interest income $11,170 $11,268 $20,895 $18,705 ======= ======= ======= ======= </TABLE> Service charges on deposit accounts increased by 16.4% to $5.0 million and by 13.9% to $9.0 million during the three- and six-month periods ended June 30, 2005, respectively, from the comparable periods in 2004. The increase in such service charges principally relates to growth in checking accounts as a result of deposit account promotions, including direct mail solicitations as well as our two bank acquisitions completed in mid-2004. Partially as a result of a leveling off in our growth rate of new checking accounts, we would expect the growth rate of service charges on deposits to moderate in future periods. Our mortgage lending activities have a substantial impact on total non-interest income. Net gains on the sale of real estate mortgage loans decreased by $0.9 million during the three months ended June 30, 2005 from the same period in 2004 and decreased by $0.5 million on a year to date comparative basis. The decline in these gains is due to both a drop in loan sales volume and the profit margin on such sales. The decrease in loan sales volume is primarily a result of a drop in mortgage loan refinance activity and a lower percentage of loans being originated for sale in 2005 compared to 2004. The lower profit margin in 2005 compared to 2004 is primarily due to pricing pressures in the marketplace as mortgage lenders are competing for a smaller total market as a result of lower mortgage loan refinance activity. We expect these market conditions to persist for the balance of the year and therefore anticipate somewhat lower levels of gains on loan sales during the last half of 2005 compared to the same period in 2004. 32
REAL ESTATE MORTGAGE LOAN ACTIVITY <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 -------- -------- -------- -------- (in thousands) <S> <C> <C> <C> <C> Real estate mortgage loans originated $186,998 $199,576 $333,960 $358,995 Real estate mortgage loans sold 95,955 137,896 183,873 206,630 Real estate mortgage loans sold with servicing rights released 11,224 16,564 21,522 24,245 Net gains on the sale of real estate mortgage loans 1,307 2,163 2,695 3,222 Net gains as a percent of real estate mortgage loans sold ("Loan Sale Margin") 1.36% 1.57% 1.47% 1.56% SFAS #133 adjustments included in the Loan Sale Margin (0.04%) (0.07%) 0.01% (0.03%) </TABLE> The volume of loans sold is dependent upon our ability to originate real estate mortgage loans as well as the demand for fixed-rate obligations and other loans that we cannot profitably fund within established interest-rate risk parameters. (See "Portfolio loans and asset quality.") Net gains on real estate mortgage loans are also dependent upon economic and competitive factors as well as our ability to effectively manage exposure to changes in interest rates. As a result this category of revenue can be quite cyclical and volatile. The second quarter of 2005 included approximately $1.3 million of net gains on securities sales. During the second quarter of 2005 we liquidated our portfolio of four different bank stocks which generated gains of approximately $1.4 million. These gains were partially offset by a $0.1 million other than temporary impairment charge recorded on Fannie Mae and Freddie Mac preferred stocks. The declines in title insurance fees in 2005 compared to 2004 primarily reflect the changes in our mortgage loan origination volume. VISA check card interchange income increased in 2005 compared to 2004. These results can be primarily attributed to an increase in the size of our card base due to growth in checking accounts as well as the two bank acquisitions completed in 2004. In addition, the frequency of use of our VISA check card product by our customer base has increased due to our marketing efforts. Manufactured home loan origination fees and commissions have stabilized in 2005 after several periods of decline. This industry has faced a challenging environment as several buyers of this type of loan have exited the market or materially altered the guidelines under which they will purchase such loans. Further, regulatory changes have reduced the opportunity to generate revenues on the sale of insurance related to this type of lending. Given these challenges, we expect the level of revenue recorded in the first two quarters of 2005 from this activity is likely to be fairly reflective of ensuing quarters, at least in the short-term. Real estate mortgage loan servicing generated income of $0.2 million and $1.2 million in the second quarter and first six months of 2005 respectively, compared to $1.8 million and $1.1 million in the corresponding periods of 2004, respectively. These variances are primarily due to changes in the impairment reserve on and the amortization of capitalized mortgage loan servicing rights. The period end impairment reserve is based on a third-party valuation of our real estate mortgage loan servicing portfolio and the amortization is primarily impacted by prepayment activity. 33
Activity related to capitalized mortgage loan servicing rights is as follows: CAPITALIZED REAL ESTATE MORTGAGE LOAN SERVICING RIGHTS <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 -------- -------- ------- ------- (in thousands) <S> <C> <C> <C> <C> Balance at beginning of period $ 12,255 $ 8,082 $11,360 $ 8,873 Originated servicing rights capitalized 824 1,110 1,579 1,800 Amortization (479) (645) (958) (1,081) (Increase)/decrease in impairment reserve (285) 1,607 334 562 -------- -------- ------- ------- Balance at end of period $ 12,315 $10,154 $12,315 $10,154 -------- -------- ------- ------- Impairment reserve at end of period $ 432 $ 160 $ 432 $ 160 ======== ======== ======= ======= </TABLE> The declines in originated mortgage loan servicing rights capitalized are due to the lower level of real estate mortgage loan sales in 2005 compared to 2004. The changes in the impairment reserve reflect the valuation of capitalized mortgage loan servicing rights at each quarter end. At June 30, 2005, we were servicing approximately $1.4 billion in real estate mortgage loans for others on which servicing rights have been capitalized. This servicing portfolio had a weighted average coupon rate of approximately 5.86% and a weighted average service fee of 25.9 basis points. Other non-interest income has increased in 2005 compared to 2004. Increases in ATM fees, insurance commissions and check printing charges have accounted for the majority of this growth. The growth is generally reflective of the overall expansion of the organization in terms of numbers of customers and accounts. NON-INTEREST EXPENSE Non-interest expense is an important component of our results of operations. However, we primarily focus on revenue growth, and while we strive to efficiently manage our cost structure, our non-interest expenses will generally increase from year to year because we are expanding our operations through acquisitions and by opening new branches and loan production offices. Non-interest expense decreased by $0.2 million to $26.0 million and increased by $5.1 million to $52.0 million during the three- and six-month periods ended June 30, 2005, respectively, compared to the like periods in 2004. The second quarter of 2004 included certain non-recurring charges totaling approximately $3.7 million as described below. The aforementioned two bank acquisitions in mid-2004 as well as growth associated with new branch offices and loan production offices account for much of the increases in non-interest expense for the first half of 2005 compared to 2004. 34
NON-INTEREST EXPENSE <TABLE> <CAPTION> Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ---------- ---------- ---------- ---------- (in thousands) <S> <C> <C> <C> <C> Salaries $ 8,659 $ 7,796 $ 17,038 $ 15,391 Performance-based compensation and benefits 1,998 1,508 4,118 2,778 Other benefits 2,520 2,550 5,500 4,784 ---------- ---------- ---------- ---------- Compensation and employee benefits 13,177 11,854 26,656 22,953 Occupancy, net 2,103 1,814 4,341 3,637 Furniture and fixtures 1,715 1,475 3,513 2,865 Mepco claims expense 2,700 2,700 Data processing 1,247 1,110 2,390 2,163 Loan and collection 1,128 877 2,084 1,624 Advertising 1,099 935 2,078 1,605 Communications 908 859 1,984 1,665 Amortization of intangible assets 694 525 1,387 977 Legal and professional 562 551 1,353 840 Supplies 614 656 1,224 1,100 Write-off of uncompleted software 977 977 Other 2,759 1,894 5,022 3,779 ---------- ---------- ---------- ---------- Total non-interest expense $ 26,006 $ 26,227 $ 52,032 $ 46,885 ========== ========== ========== ========== </TABLE> The increases in compensation and benefits in 2005 compared to 2004 are primarily attributable to an increased number of employees resulting from acquisitions and the addition of new branch and loan production offices as well as to merit pay increases and increases in certain employee benefit costs such as health care insurance. Performance based compensation and benefits increased in 2005 compared to 2004 due primarily to an increased funding level for our employee stock ownership plan and higher incentive compensation. We maintain performance-based compensation plans. In addition to commissions and cash incentive awards, such plans include employee stock ownership and employee stock option plans. In December 2004 the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123 (revised 2004), "Share-Based Payment" ("SFAS #123R") (See note #11 of Notes to Interim Consolidated Financial Statements). In general this accounting pronouncement requires that all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. Originally this new requirement would have applied to us beginning on July 1, 2005, however the Securities and Exchange Commission recently extended the date to January 1, 2006. Occupancy, furniture and fixtures, data processing, advertising, communications and other non-interest expenses all generally increased in 2005 compared to 2004 as a result of the growth of the organization through acquisitions and the opening of new branch and loan production offices. The increase in amortization of intangible assets is also a result of acquisitions. The increases in loan and collection expense reflects costs associated with holding or disposal of other real estate and collection costs associated with increases in the level of non-performing loans. 35
The second quarter of 2004 included non-recurring charges at Mepco of $1.0 million for the write-off of uncompleted software and $2.7 million to establish a liability related to loan overpayments, as previously reported. INCOME TAX EXPENSE Our effective income tax rate was higher during both the second quarter of and for the first six months of 2005 compared to the like periods in 2004. These increases are primarily due to tax exempt interest income representing a lower percentage of pre-tax earnings and an increase in state income taxes due to higher earnings at Mepco. The primary reason for the difference between our statutory and effective income tax rates results from tax exempt interest income. ACQUISITIONS On July 1, 2004, we completed the acquisition of North. We issued 345,391 shares of common stock to the North shareholders. 2005 includes the results of North's operations. At the time of acquisition, North had total assets of $155.1 million, total loans of $103.6 million, total deposits of $123.8 million and total stockholders' equity of $3.3 million. We recorded purchase accounting adjustments related to the North acquisition including recording goodwill of $2.8 million and establishing a core deposit intangible of $2.2 million. On May 31, 2004, we completed the acquisition of Midwest. We issued 997,700 shares of common stock and paid $16.6 million in cash to the Midwest shareholders. 2005 includes the results of Midwest's operations. At the time of acquisition, Midwest had total assets of $238.0 million, total loans of $205.0 million, total deposits of $198.9 million and total stockholders' equity of $18.7 million. We recorded purchase accounting adjustments related to the Midwest acquisition including recording goodwill of $23.0 million, establishing a core deposit intangible of $4.9 million, and a covenant not to compete of $1.3 million. CRITICAL ACCOUNTING POLICIES Our accounting and reporting policies are in accordance with accounting principles generally accepted within the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for other than temporary impairment of investment securities, the allowance for loan losses, originated real estate mortgage servicing rights, derivative financial instruments, income taxes and goodwill are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those that we have used could result in material changes in our financial position or results of operations. We are required to assess our investment securities for "other than temporary impairment" on a periodic basis. The determination of other than temporary impairment for an investment security requires judgment as to the cause of the impairment, the likelihood of recovery and the projected timing of the recovery. Our assessment process during the second quarter and first six months of 2005 resulted in recording $0.1 million and $0.3 million of impairment charges, respectively, for other than temporary impairment on various investment securities within our portfolio (we had no such impairment charges during the first six months of 2004). Currently the accounting profession (FASB) is considering the meaning of other than temporary impairment with respect to debt securities and has rescinded the effective date of certain portions of a recent accounting pronouncement (see note #11 of Notes to Interim Consolidated Financial Statements) that would have impacted this area. We believe that our assumptions and judgments in assessing other than temporary impairment for our investment securities are reasonable and conform to general industry practices. 36
Our methodology for determining the allowance and related provision for loan losses is described above in "Financial Condition - Portfolio Loans and asset quality." In particular, this area of accounting requires a significant amount of judgment because a multitude of factors can influence the ultimate collection of a loan or other type of credit. It is extremely difficult to precisely measure the amount of losses that are probable in our loan portfolio. We use a rigorous process to attempt to accurately quantify the necessary allowance and related provision for loan losses, but there can be no assurance that our modeling process will successfully identify all of the losses that are probable in our loan portfolio. As a result, we could record future provisions for loan losses that may be significantly different than the levels that we have recorded in the most recent quarter. At June 30, 2005 we had approximately $12.3 million of real estate mortgage loan servicing rights capitalized on our balance sheet. There are several critical assumptions involved in establishing the value of this asset including estimated future prepayment speeds on the underlying real estate mortgage loans, the interest rate used to discount the net cash flows from the real estate mortgage loan servicing, the estimated amount of ancillary income that will be received in the future (such as late fees) and the estimated cost to service the real estate mortgage loans. We utilize an outside third party (with expertise in the valuation of real estate mortgage loan servicing rights) to assist us in our valuation process. We believe the assumptions that we utilize in our valuation are reasonable based upon accepted industry practices for valuing mortgage servicing rights and represent neither the most conservative or aggressive assumptions. We use a variety of derivative instruments to manage our interest rate risk. These derivative instruments include interest rate swaps, collars, floors and caps and mandatory forward commitments to sell real estate mortgage loans. Under SFAS #133 the accounting for increases or decreases in the value of derivatives depends upon the use of the derivatives and whether the derivatives qualify for hedge accounting. In particular, we use pay fixed interest-rate swaps to convert the variable rate cash flows on short-term or variable rate debt obligations to fixed rates. At June 30, 2005 we had approximately $341 million in fixed pay interest rate swaps being accounted for as cash flow hedges, thus permitting us to report the related unrealized gains or losses in the fair market value of these derivatives in other comprehensive income and subsequently reclassify such gains or losses into earnings as yield adjustments in the same period in which the related interest on the hedged item (primarily short-term or variable rate debt obligations) affect earnings. The fair market value of our fixed pay interest-rate swaps being accounted for as cash flow hedges is approximately $1.5 million at June 30, 2005. Our accounting for income taxes involves the valuation of deferred tax assets and liabilities primarily associated with differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. At December 31, 2004 we had recorded a net deferred tax asset of $8.7 million, which included a net operating loss carryforward of $6.8 million. We have recorded no valuation allowance on our net deferred tax asset because we believe that the tax benefits associated with this asset will more likely than not, be realized. However, changes in tax laws, changes in tax rates and our future level of earnings can adversely impact the ultimate realization of our net deferred tax asset. At June 30, 2005 we had recorded $53.8 million of goodwill. Under SFAS #142, amortization of goodwill ceased, and instead this asset must be periodically tested for impairment. Our goodwill primarily arose from the 2004 acquisitions of Midwest and North, the 2003 acquisition of Mepco and the past acquisitions of other banks and a mobile home loan origination company. We test our goodwill for impairment utilizing the methodology and guidelines established in SFAS #142. This methodology involves assumptions regarding the valuation of the business segments that contain the acquired entities. We believe that the assumptions we utilize are reasonable. 37
However, we may incur impairment charges related to our goodwill in the future due to changes in business prospects or other matters that could affect our valuation assumptions. LITIGATION MATTERS In May 2004, we received an unsolicited anonymous letter regarding certain business practices at Mepco, which was acquired in April 2003 and is now a wholly-owned subsidiary of Independent Bank. We processed this letter in compliance with our Policy Regarding the Resolution of Reports on the Company's Accounting, Internal Controls and Other Business Practices. Under the direction of our Audit Committee, special legal counsel was engaged to investigate the matters raised in the anonymous letter. This investigation was completed during the first quarter of 2005 and we have determined that any amounts or issues relating to the period after our April 2003 acquisition of Mepco were not significant. The potential amount of liability related to periods prior to our April 2003 acquisition date has been determined to not exceed approximately $5 million. This potential liability primarily encompasses funds that may be due to former customers of Mepco related to loan overpayments or unclaimed funds that may be subject to escheatment. Prior to our acquisition, Mepco had erroneously recorded these amounts as revenue over a period of several years. The final liability may, however, be less, depending on the facts related to each loan account, the application of the law to those facts and the applicable state escheatment requirements for unclaimed funds. In the second quarter of 2004 we recorded a liability of $2.7 million with a corresponding charge to earnings (included in non-interest expenses) for potential amounts due to third parties (either former loan customers or to states for the escheatment of unclaimed funds). On September 30, 2004 we entered into an escrow agreement with the primary former shareholders of Mepco. This escrow agreement was entered into for the sole purpose of funding any obligations beyond the $2.7 million amount that we already had accrued. The escrow agreement gives us the right to have all or a portion of the escrow account distributed to us from time to time if the aggregate amount that we (together with any of our affiliates including Mepco) are required to pay to any third parties as a result of the matters being investigated exceeds $2.7 million. At June 30, 2005, the escrow account contained 90,766 shares of Independent Bank Corporation common stock (deposited by the primary former shareholders of Mepco) having an aggregate market value at that date of approximately $2.6 million. The escrow agreement contains provisions that require the addition or distribution of shares of Independent Bank Corporation common stock if the total market value of such stock in the escrow account falls below $2.25 million or rises above $2.75 million. As a result of the aforementioned escrow agreement as well as the $2.7 million accrual established in the second quarter of 2004, we do not expect any future liabilities (other than ongoing litigation costs) related to the Mepco investigation. The terms of the agreement under which we acquired Mepco, obligates the former shareholders of Mepco to indemnify us for existing and resulting damages and liabilities from pre-acquisition activities at Mepco. On April 12, 2005, we filed a Notice of Indemnification Claims with the former shareholders of Mepco. In the notice, we requested the payment of all accrued and incurred costs, liabilities and damages, and as permitted by the Agreement, reimbursement of all potential contingent claims. Our indemnification claims include approximately $1.0 million in costs that we have incurred to date for the above described investigation. There can be no assurance that we will successfully prevail with respect to these claims. On March 23, 2005 Edward M. Walder and Paul M. Walder (collectively the "Walders") filed suit against Independent Bank Corporation and Mepco in the Circuit Court of Cook County, Illinois. In general, the suit alleges various breaches of the merger agreement between 38
Independent Bank Corporation and Mepco, the employment agreements with the Walders and the above mentioned escrow agreement. The suit seeks unspecified damages and rescission of the merger agreement, covenants not to compete and the escrow agreement. We believe that the suit filed by the Walders is without merit and intend to vigorously defend this matter. On May 25, 2005 Independent Bank Corporation and Mepco filed suit against the Walders and their respective trusts in Ionia County Circuit Court. In general the suit seeks to enforce our indemnification rights under the merger agreement and seeks damages as a result of the Walders breach of the merger agreement and misrepresentations. We are also involved in various other litigation matters in the ordinary course of business and at the present time, we do not believe that any of these matters will have a significant impact on our financial condition or results of operation. 39
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK No material changes in the market risk faced by the Registrant have occurred since December 31, 2004. Item 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures. With the participation of management, our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)) for the period ended June 30, 2005, have concluded that, as of such date, our disclosure controls and procedures were effective. (b) Changes in Internal Controls. During the quarter ended June 30, 2005, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 40
Part II Item 2. Unregistered sales of equity securities and use of proceeds The following table shows certain information relating to purchases of common stock for the three-months ended June 30, 2005 pursuant to the our share repurchase plan: <TABLE> <CAPTION> Remaining Total Number of Number of Shares Purchased Shares as Part of a Authorized for Total Number of Average Price Publicly Purchase Under Period Shares Purchased Paid Per Share Announced Plan(2) the Plan - ------------ ---------------- -------------- ----------------- ---------------- <S> <C> <C> <C> <C> April 2005(1) 305 27.32 305 May 2005 150,000 27.15 150,000 June 2005(1) 2,041 28.44 2,041 ------- ----- ------- ------- Total 152,346 27.17 152,346 596,419 ======= ===== ======= ======= </TABLE> (1)Represents shares purchased to fund our Deferred Compensation and Stock Purchase Plan for Non-employee Directors. (2)Our current stock repurchase plan authorizes the purchase up to 750,000 shares of our common stock. The repurchase plan expires on December 31, 2005. Item 4. Submission of Matters to a Vote of Security-Holders Our Annual Meeting of Shareholders was held on April 26, 2005. As described in our proxy statement, dated March 21, 2005, the following matters were considered at that meeting: (1) Election of directors: Stephen L. Gulis, Jr., Terry L. Haske, and Charles A. Palmer were elected to serve three-year terms expiring in 2008 and Michael M. Magee, Jr. was elected to serve a one-year term expiring in 2006. Votes for and votes withheld for each nominee were as follows: <TABLE> <CAPTION> Votes For Votes Withheld ---------- -------------- <S> <C> <C> Stephen L. Gulis, Jr 17,408,334 707,967 Terry L. Haske 17,005,953 1,110,348 Charles A. Palmer 16,914,119 1,202,182 Michael M. Magee, Jr 17,428,662 687,639 </TABLE> Directors whose term of office as a director continued after the meeting were Robert L. Hetzler, James E. McCarty, Jeffrey A. Bratsburg and Charles C. Van Loan. (2) An amendment to our Long-Term Incentive Plan to make an additional 750,000 shares of our common stock available under the plan was approved. Votes for, votes against and abstentions were as follows: <TABLE> <S> <C> Votes for: 10,251,865 Votes against: 2,316,793 Abstain: 412,218 </TABLE> 41
Part II (continued) Item 6. Exhibits (a) The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report: 11. Computation of Earnings Per Share. 31.1 Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 31.2 Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 32.1 Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 32.2 Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 42
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. Date August 5, 2005 By /s/ Robert N. Shuster ------------------------------------------ Robert N. Shuster, Principal Financial Officer Date August 5, 2005 By /s/ James J. Twarozynski ------------------------------------------ James J. Twarozynski, Principal Accounting Officer 43
EXHIBIT INDEX Exhibits (a) The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report: 11. Computation of Earnings Per Share. 31.1 Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 31.2 Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 32.1 Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). 32.2 Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).