1 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 MARCH 31, 1999 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at May 10, 1999 - --------------------------------- ------------------------------------------- Common stock, par value $1 7,448,683
2 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES INDEX <TABLE> <CAPTION> Page Number(s) --------- <S> <C> <C> PART I - Financial Information Item 1. Consolidated Statements of Financial Condition March 31, 1999 and December 31, 1998 2 Consolidated Statements of Operations Three-month periods ended March 31, 1999 and 1998 3 Consolidated Statements of Cash Flows Three-month periods ended March 31, 1999 and 1998 4 Consolidated Statements of Shareholders' Equity Three-month periods ended March 31, 1999 and 1998 5 Notes to Interim Consolidated Financial Statements Three-month periods ended March 31, 1999 and 1998 6-8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-18 Item 3. Quantitative and Qualitative Disclosures about Market Risk 18 PART II - Other Information Item 6. Exhibits & Reports on Form 8-K 19 </TABLE>
3 Part I. INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition <TABLE> <CAPTION> March 31, December 31, 1999 1998 ---------------- ----------------- Assets (unaudited) ---------------- ----------------- <S> <C> <C> Cash and due from banks $ 33,174,000 $ 42,846,000 Securities available for sale 88,793,000 99,515,000 Securities held to maturity (Fair value of $16,674,000 at March 31, 1999; $19,029,000 at December 31, 1998) 16,100,000 18,349,000 Federal Home Loan Bank stock, at cost 12,589,000 12,589,000 Loans held for sale 29,564,000 39,741,000 Loans Commercial and agricultural 245,457,000 238,863,000 Real estate mortgage 439,969,000 449,114,000 Installment 137,317,000 134,627,000 ---------------- ---------------- Total Loans 822,743,000 822,604,000 Allowance for loan losses (9,989,000) (9,714,000) ---------------- ---------------- Net Loans 812,754,000 812,890,000 Property and equipment, net 28,379,000 27,255,000 Accrued income and other assets 33,187,000 32,073,000 ---------------- ---------------- Total Assets $ 1,054,540,000 $ 1,085,258,000 ================ ================ Liabilities and Shareholders' Equity Deposits Non-interest bearing $ 98,293,000 $ 112,930,000 Savings and NOW 382,744,000 377,592,000 Time 335,418,000 339,992,000 ---------------- ---------------- Total Deposits 816,455,000 830,514,000 Federal funds purchased 16,100,000 22,650,000 Other borrowings 118,823,000 130,964,000 Guaranteed preferred beneficial interests in Company's subordinated debentures 17,250,000 17,250,000 Accrued expenses and other liabilities 14,038,000 14,175,000 ---------------- ---------------- Total Liabilities 982,666,000 1,015,553,000 ---------------- ---------------- Shareholders' Equity Preferred stock, no par value--200,000 shares authorized; none outstanding Common stock, $1.00 par value--14,000,000 shares authorized; issued and outstanding: 7,426,991 shares at March 31, 1999 and 7,382,506 shares at December 31, 1998 7,427,000 7,383,000 Capital surplus 38,464,000 37,658,000 Retained earnings 24,474,000 22,749,000 Accumulated other comprehensive income 1,509,000 1,915,000 ---------------- ---------------- Total Shareholders' Equity 71,874,000 69,705,000 ================ ---------------- Total Liabilities and Shareholders' Equity $ 1,054,540,000 $ 1,085,258,000 ================ ================ </TABLE> See notes to interim consolidated financial statements. 2
4 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations <TABLE> <CAPTION> Three Months Ended March 31, 1999 1998 -------------- -------------- (unaudited) ----------------------------- <S> <C> <C> Interest Income Interest and fees on loans $ 19,508,000 $ 18,383,000 Securities Taxable 1,067,000 1,479,000 Tax-exempt 823,000 609,000 Other investments 249,000 247,000 ------------ ----------- Total Interest Income 21,647,000 20,718,000 ------------ ----------- Interest Expense Deposits 6,444,000 5,839,000 Other borrowings 2,334,000 3,119,000 ------------ ----------- Total Interest Expense 8,778,000 8,958,000 ------------ ----------- Net Interest Income 12,869,000 11,760,000 Provision for loan losses 525,000 633,000 ------------ ----------- Net Interest Income After Provision for Loan Losses 12,344,000 11,127,000 ------------ ----------- Non-interest Income Service charges on deposit accounts 1,038,000 823,000 Net gains on asset sales Real estate mortgage loans 1,248,000 907,000 Securities 14,000 137,000 Other income 1,391,000 761,000 ------------ ----------- Total Non-interest Income 3,691,000 2,628,000 ------------ ----------- Non-interest Expense Salaries and employee benefits 6,810,000 5,911,000 Occupancy, net 870,000 699,000 Furniture and fixtures 745,000 579,000 Other expenses 3,721,000 3,142,000 ------------ ----------- Total Non-interest Expense 12,146,000 10,331,000 ------------ ----------- Income Before Federal Income Tax 3,889,000 3,424,000 Federal income tax expense 1,124,000 991,000 ------------ ----------- Net Income $ 2,765,000 $ 2,433,000 ============ =========== Net income per common share Basic $ .37 $ .33 Diluted .37 .33 Dividends Per Common Share Declared $ .140 $ .124 Paid .130 .117 </TABLE> See notes to interim consolidated financial statements. 3
5 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows <TABLE> <CAPTION> Three months ended March 31, 1999 1998 --------------- --------------- (unaudited) ------------------------------- <S> <C> <C> Net Income $ 2,765,000 $ 2,433,000 --------------- ------------ Adjustments to Reconcile Net Income to Net Cash from Operating Activities Proceeds from sales of loans held for sale 74,186,000 58,421,000 Disbursements for loans held for sale (62,761,000) (78,914,000) Provision for loan losses 525,000 633,000 Deferred loan fees 14,000 70,000 Amortization of intangible assets 442,000 379,000 Depreciation and amortization of premiums and accretion of discounts on securities and loans 777,000 664,000 Net gains on sales of real estate mortgage loans (1,248,000) (907,000) Net gains on sales of securities (14,000) (137,000) Increase in accrued income and other assets (1,556,000) (652,000) Increase in accrued expenses and other liabilities 617,000 2,187,000 --------------- ------------ Total Adjustments 10,982,000 (18,256,000) --------------- ------------ Net Cash from Operating Activities 13,747,000 (15,823,000) --------------- ------------ Cash Flow from Investing Activities Proceeds from the sale of securities available for sale 267,000 4,366,000 Proceeds from the maturity of securities available for sale 7,000,000 3,027,000 Proceeds from the maturity of securities held to maturity 2,255,000 1,034,000 Principal payments received on securities available for sale 4,398,000 3,341,000 Principal payments received on securities held to maturity 306,000 621,000 Purchases of securities available for sale (1,817,000) (2,232,000) Principal payments on portfolio loans purchased 3,995,000 4,830,000 Portfolio loans made to customers, net of principal payments received (4,398,000) (2,065,000) Capital expenditures (1,909,000) (1,417,000) --------------- ------------ Net Cash from Investing Activities 10,097,000 11,505,000 --------------- ------------ Cash Flow from Financing Activities Net increase (decrease) in total deposits (14,059,000) 10,284,000 Net decrease in short-term borrowings (7,191,000) (4,371,000) Proceeds from Federal Home Loan Bank advances 11,000,000 Payments of Federal Home Loan Bank advances (11,000,000) (11,000,000) Retirement of long-term debt (500,000) (500,000) Dividends paid (960,000) (848,000) Proceeds from issuance of common stock 194,000 227,000 --------------- ------------ Net Cash from Financing Activities (33,516,000) 4,792,000 --------------- ------------ Net Increase (Decrease) in Cash and Cash Equivalents (9,672,000) 474,000 Cash and Cash Equivalents at Beginning of Period 42,846,000 30,371,000 --------------- ------------ Cash and Cash Equivalents at End of Period $ 33,174,000 $ 30,845,000 =============== ============ Cash paid during the period for Interest $ 8,703,000 $ 8,932,000 Income taxes 200,000 Transfer of loans to other real estate 642,000 399,000 </TABLE> See notes to interim consolidated financial statements 4
6 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity <TABLE> <CAPTION> Three months ended March 31, 1999 1998 -------------- ------------- (unaudited) ----------------------------- <S> <C> <C> Balance at beginning of period $ 69,705,000 $ 59,516,000 Net income 2,765,000 2,433,000 Cash dividends declared (1,040,000) (902,000) Issuance of common stock 850,000 1,129,000 Net change in unrealized gain on securities available for sale, net of related tax effect (note 4) (406,000) (62,000) ------------- ------------- Balance at end of period $ 71,874,000 $ 62,114,000 ============= ============== </TABLE> See notes to interim consolidated financial statements. 5
7 NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. In the opinion of management of the Registrant, the accompanying unaudited consolidated financial statements contain all the adjustments (consisting only of normal recurring accruals) necessary to present fairly the consolidated financial condition of the Registrant as of March 31, 1999 and December 31, 1998, and the results of operations for the three-month periods ended March 31, 1999 and 1998. 2. Management's 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 $5,370,000 at March 31, 1999, and $6,641,000 at December 31, 1998. (See Management's Discussion and Analysis of Financial Condition and Results of Operations). 3. The provision for income taxes represents federal income tax expense calculated using annualized rates on taxable income generated during the respective periods. 4. The Registrant adopted Statement of Financial Accounting Standards, No. 130, "Reporting Comprehensive Income", (SFAS #130) effective January 1, 1998. SFAS #130 establishes standards for reporting and displaying comprehensive income and its components, including but not limited to unrealized gains and losses on securities available for sale. Comprehensive income for the three-month periods ending March 31 follows: <TABLE> <CAPTION> Three months ended March 31, 1999 1998 --------------- ------------- <S> <C> <C> Net income $ 2,765,000 $ 2,433,000 Net change in unrealized gain on securities available for sale, net of related tax effect (406,000) (62,000) ============ ============ Comprehensive income $ 2,359,000 $ 2,371,000 ============ ============ </TABLE> 5. The Registrant adopted Statement of Financial Accounting Standards, No. 131, "Disclosures about Segments of an Enterprise and Related Information", (SFAS #131) on January 1, 1998. SFAS #131 establishes standards for the way that public entities report information about operating segments in financial statements. The Registrant's reportable segments are based upon legal entities. The Registrant has four reportable segments: Independent Bank ("IB"), Independent Bank West Michigan ("IBWM"), Independent Bank South Michigan ("IBSM") and Independent Bank East Michigan ("IBEM"). The Registrant evaluates performance based principally on net income of the respective reportable segments. 6
8 NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) A summary of selected financial information for the Registrant's reportable segments at March 31, follows: <TABLE> <CAPTION> IB IBWM IBSM IBEM OTHER(1) TOTAL ------------------------------------------------------------------------------- (in thousands) <S> <C> <C> <C> <C> <C> <C> 1999 Total assets $ 358,112 $ 268,308 $ 161,955 $ 260,757 $ 5,408 $ 1,054,540 Interest income 7,217 6,207 3,357 4,861 5 21,647 Net interest income 4,466 3,875 2,068 3,022 (562) 12,869 Provision for loan losses 150 135 90 150 525 Income (loss) before Income tax 1,667 1,436 793 905 (912) 3,889 Net income (loss) 1,150 989 577 680 (631) 2,765 1998 Total assets $ 342,843 $ 247,351 $ 157,810 $ 238,725 $ 6,406 $ 993,135 Interest income 6,954 5,791 3,324 4,644 5 20,718 Net interest income 4,122 3,584 1,890 2,766 (602) 11,760 Provision for loan losses 165 195 75 198 633 Income (loss) before Income tax 1,573 1,327 755 774 (1,005) 3,424 Net income (loss) 1,087 929 548 551 (682) 2,433 </TABLE> (1) Includes items relating to the Registrant and certain insignificant operations. 6. A reconciliation of basic and diluted earnings per share for the three-month periods ending, March 31 follows: <TABLE> <CAPTION> Three months ended March 31, 1999 1998 ------------- ------------- <S> <C> <C> Net income $ 2,765,000 $ 2,433,000 ============ ============ Shares outstanding (Basic) (1) 7,411,000 7,264,000 Effect of dilutive securities - stock options 62,000 94,000 ------------ ------------ Shares outstanding (Diluted) 7,473,000 7,358,000 ============ ============ Earnings per share Basic $ .37 $ .33 Diluted .37 .33 </TABLE> (1) Shares outstanding have been adjusted for a three-for-two stock split and a 5% stock dividend in 1998. 7
9 NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 7. The Financial Accounting Standards Board adopted Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative Instruments and Hedging Activities", ("SFAS #133") in June 1998. SFAS #133 requires companies to record derivatives on the balance sheet as assets and liabilities measured at fair value. The accounting for increases and decreases in the value of those derivatives will depend upon the use of those derivatives and whether or not they qualify for hedge accounting. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999 with earlier application allowed and is to be applied prospectively. The adoption of this statement is not expected to have a material impact on the Registrant's financial statements. 8. The results of operations for the three-month period ended March 31, 1999, are not necessarily indicative of the results to be expected for the full year. 8
10 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of financial condition and results of operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in such forward-looking statements. The following section presents additional information that may be necessary to assess the financial condition and results of operations of the Registrant and its subsidiary banks (the "Banks"). This section should be read in conjunction with the consolidated financial statements contained elsewhere in this report as well as the Registrant's 1998 Annual Report on Form 10-K. FINANCIAL CONDITION SUMMARY Assets totaled $1,054.5 million at March 31, 1999. The $30.8 million decline in total assets from $1,085.3 million at December 31, 1998, principally reflects a $13.0 million decrease in the Bank's securities portfolios as well as a $10.2 million decrease in loans held for sale. (See "Securities.") Loans, excluding loans held for sale ("Portfolio Loans"), were largely unchanged from December 31, 1998, as an increase in commercial and agricultural loans largely offset a decline in real estate mortgage loans. (See "Asset/liability management.") Deposits totaled $816.5 million at March 31, 1999, compared to $830.5 million at December 31, 1998. The $14.0 million decline in total deposits principally reflects the cash management needs of the Banks' corporate and municipal depositors. (See "Deposits and borrowings.") SECURITIES The Banks maintain diversified securities portfolios that include obligations of the U.S. Treasury and government-sponsored agencies as well as securities issued by states and political subdivisions, corporate notes and mortgage-backed securities. Management continually evaluates the Banks' asset/liability management needs and attempts to maintain a portfolio structure that provides sufficient liquidity and cash flow. (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 March 31, 1999 $ 86,471 $ 2,322 $ 0 $ 88,793 December 31, 1998 96,614 2,948 47 99,515 Securities held to maturity March 31, 1999 $ 16,100 $ 576 $ 2 $ 16,674 December 31, 1998 18,349 688 8 19,029 </TABLE> The sale of securities available for sale is dependent upon Management's assessment of reinvestment opportunities and the Banks' asset/liability management needs. As a result of such ongoing evaluations, the Banks sold securities with an aggregate market value of approximately 9
11 $267,000 during the three-month period ended March 31, 1999, compared to $4.4 million during the comparable period in 1998. The Banks realized net gains on the sale of such securities totaling $14,000 and $137,000 during the three months ended March 31, 1999 and 1998, respectively. SALES OF SECURITIES AVAILABLE FOR SALE <TABLE> <CAPTION> Three months ended March 31, 1999 1998 ----------- ------------- <S> <C> <C> Proceeds $ 267,000 $ 4,366,000 ========= =========== Gross gains $14,000 $137,000 Gross losses --------- ----------- Net Gains (losses) $14,000 $137,000 ========= =========== </TABLE> ASSET QUALITY Management believes that the Registrant's decentralized structure provides important advantages in serving the credit needs of the Banks' principal lending markets. In addition to the communities served by the Banks' branch networks, principal lending markets include nearby communities and metropolitan areas. Subject to established underwriting criteria, the Banks also participate in commercial lending transactions with certain non-affiliated banks and may also purchase real estate mortgage loans from third-party originators. Although the Management and Board of Directors of each Bank retain authority and responsibility for credit decisions, each of the Banks has adopted uniform underwriting standards. Further, the Registrant's loan committee as well as the centralization of commercial loan credit services and loan review functions promote compliance with such established underwriting standards. The centralization of retail loan services also provides for consistent service quality and facilitates compliance with consumer protection laws and regulations. NON-PERFORMING ASSETS <TABLE> <CAPTION> March 31, December 31, 1999 1998 --------------- ----------------- <S> <C> <C> Non-accrual loans $ 3,276,000 $ 4,106,000 Loans 90 days or more past due and still accruing interest 1,814,000 2,240,000 Restructured loans 280,000 295,000 ----------- ----------- Total non-performing loans 5,370,000 6,641,000 Other real estate 1,578,000 936,000 =========== =========== Total non-performing assets $ 6,948,000 $ 7,577,000 =========== =========== As a percent of Portfolio Loans Non-performing loans 0.65 % 0.81 % Non-performing assets 0.84 0.92 Allowance for loan losses 1.21 1.18 Allowance for loan losses as a percent of non-performing loans 186 146 </TABLE> 10
12 Impaired loans totaled approximately $3,400,000 at March 31, 1999. At that same date, certain impaired loans with a balance of approximately $1,400,000, had specific allocations of the allowance for loan losses calculated in accordance with Statement of Financial Accounting Standards #114 totaling approximately $300,000. The Banks' average investment in impaired loans was approximately $3,400,000, for the three-month period ending March 31, 1999. Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance. Interest recognized on impaired loans during that three-month period was approximately $40,000. Loans charged against the allowance for loan losses, net of recoveries, were equal to .12% of average loans during the three months ended March 31, 1999, compared to .18% during the comparable period of 1998. ALLOWANCE FOR LOAN LOSSES <TABLE> <CAPTION> Three months ended March 31, 1999 1998 --------------- -------------- <S> <C> <C> Balance at beginning of period $9,714,000 $7,670,000 Additions (deduction) Provision charged to operating expense 525,000 633,000 Recoveries credited to allowance 162,000 119,000 Loans charged against the allowance (412,000) (447,000) ========== ========== Balance at end of period $9,989,000 $7,975,000 ========== ========== Net loans charged against the allowance to average Portfolio Loans (annualized) 0.12% 0.18% </TABLE> Management's assessment of the allowance for loan losses is based on the composition of the loan portfolio, an evaluation of specific credits, historical loss experience as well as the level of non-performing and impaired loans. Based upon such assessment, Management does not believe there has been a material change in the adequacy of the allowance for loan losses. (See "Provision for loan losses.") DEPOSITS AND BORROWINGS The Banks' competitive position within many of the markets served by the branch networks limits the ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits. Accordingly, Management employs pricing tactics that are intended to enhance the value of core deposits and the Banks' have implemented funding strategies that incorporate other borrowings and brokered certificates of deposits ("Brokered CDs") to finance a portion of the Portfolio Loans. The use of such alternate sources of funds is also an integral part of the Banks' asset/liability management efforts. <TABLE> <CAPTION> March 31, 1999 December 31, 1998 ------------------------------- --------------------------------- Average Average Amount Maturity Rate Amount Maturity Rate ------ -------- ---- ------ -------- ---- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Brokered CDs $52,905 5.1 years 5.71% $54,885 4.4 years 5.64% Fixed rate FHLB advances 50,569 3.3 years 5.75 50,569 3.5 years 5.75 Variable rate FHLB advances 57,500 0.4 years 5.05 68,500 0.5 years 5.21 </TABLE> 11
13 Other borrowed funds, principally advances from the Federal Home Loan Bank (the "FHLB"), decreased to $118.8 million at March 31, 1999, from $131.0 million at December 31, 1998. To diversify the Banks' funding sources, the Banks also employ Brokered CDs. Brokered CDs totaled $52.9 million and $54.9 million at March 31, 1999 and December 31, 1998, respectively. INTEREST-RATE DERIVATIVE FINANCIAL INSTRUMENTS <TABLE> <CAPTION> SWAPS ----------------------------------------- CAPS COLLARS PAY FIXED PAY VARIABLE - ------------------------------------------------------------------------------------------------------------------------- (dollars in thousands) <S> <C> <C> <C> <C> Notional amount $ 26,000 $ 10,000 $ 58,500 $ 29,000 Weighted-average maturity 1.0 years 1.5 years 2.9 years 8.9 years Cap strike 6.69% 6.42% Floor strike 5.71 Rate paying 5.29% 5.18% Rate receiving 5.00 5.91 Premium paid $ 246 Annual cost .26% Amortized cost $ 76 Fair value 9 $ (85) $ 89 $ (567) </TABLE> Derivative financial instruments are employed to reduce the cost of alternate funding sources and manage the Banks' exposure to changes in interest rates. (See "Asset/liability management.") At March 31, 1999, the Company employed interest-rate caps and collars with a notional amount of $26.0 million and $10.0 million, respectively. The Banks also employed interest-rate swaps with an aggregate notional amount of $87.5 million. LIQUIDITY AND CAPITAL RESOURCES Effective management of the Registrant's capital resources is critical to Management's mission to create value for the Registrant's shareholders. To profitably deploy capital within existing markets, the Banks have implemented balance sheet management strategies that combine effective loan origination efforts with disciplined funding strategies. Although the Banks' balance sheet management strategies provide profitable opportunities to leverage the balance sheet, Management believes that its acquisition strategy may provide greater value to the Registrant's shareholders. The Registrant's cost of capital is also an important factor in creating shareholder value. Accordingly, the Registrant's capital structure includes unsecured debt and Preferred Securities. CAPITALIZATION <TABLE> <CAPTION> March 31, December 31, 1999 1998 ------------------ ------------------ <S> <C> <C> Unsecured debt $ 9,500,000 $10,000,000 Preferred Securities 17,250,000 17,250,000 Shareholders' Equity Preferred stock, no par value Common Stock, par value $1.00 per share 7,427,000 7,383,000 Capital surplus 38,464,000 37,658,000 Retained earnings 24,474,000 22,749,000 Accumulated other comprehensive income 1,509,000 1,915,000 ----------- ----------- Total shareholders' equity 71,874,000 69,705,000 ---------- ----------- Total capitalization $98,624,000 $96,955,000 =========== =========== </TABLE> 12
14 Shareholders' equity totaled $71.9 million at March 31, 1999. In addition to the retention of earnings, the $2.2 million increase from $69.7 million at December 31, 1998, reflects the issuance of common stock pursuant to various equity-based incentive compensation plans. Shareholders' equity was equal to 6.82% of total assets at March 31, 1999, compared to 6.42% at December 31, 1998. CAPITAL RATIOS <TABLE> <CAPTION> March 31, 1999 December 31, 1998 ------------------- ---------------------- <S> <C> <C> Equity capital 6.82% 6.42% Average shareholders equity to average assets(1) 6.73 6.42 Tier 1 leverage (tangible equity capital) 6.70 6.23 Tier 1 risk-based capital 9.18 8.72 Total risk-based capital 10.43 9.97 </TABLE> (1) Based on year to date average balances for the respective periods ASSET/LIABILITY MANAGEMENT Interest-rate risk is created by differences in the pricing characteristics of the Banks' 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. The asset/liability management efforts of the Registrant and the Banks are intended to identify sources of interest-rate risk and to evaluate opportunities to structure the balance sheet in a manner that is consistent with Management's mission to maintain profitable financial leverage. The marginal cost of funds is a principal consideration in the implementation of the Bank's balance sheet management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. Management employs simulation analyses to monitor the Banks' interest-rate risk profiles and evaluate potential changes in the Bank's net interest income and market value of portfolio equity that result from changes in interest rates. At March 31, 1999, each of the Banks was within established parameters for interest-rate risk. Management has determined that the retention of certain real estate mortgage loans, generally 15- and 30-year fixed rate obligations, is inconsistent with its goal to maintain profitable leverage or the Banks' interest-rate risk profiles. Accordingly, the majority of such loans are sold to mitigate exposure to changes in interest rates. Adjustable-rate and balloon real estate mortgage loans may often be profitably funded within established risk parameters. The retention of such loans, together with commercial and agricultural loans, has been a principal focus of the Banks' balance sheet management strategies. (See "Non-interest income.") RESULTS OF OPERATIONS SUMMARY Net income totaled $2,765,000 during the three months ended March 31, 1999, compared to $2,433,000 during the comparable period of 1998. The double-digit percentage increase in earnings is principally the result of increases in net interest income and non-interest income that were partially offset by increases in non-interest expense. 13
15 Key performance ratios for the three-month periods ended March 31, 1999 and 1998, are set forth below. KEY PERFORMANCE RATIOS <TABLE> <CAPTION> Three months ended March 31, 1999 1998 ---------------------------- <S> <C> <C> Net income to Average assets 1.05% 1.01% Average equity 15.66 16.06 Earnings per common share Basic $.37 $.33 Diluted .37 .33 Cash basis income to(A) Average tangible assets 1.21% 1.16% Average tangible equity 23.85 24.93 Cash basis income per share(A) Basic $.42 $.38 Diluted .42 .37 </TABLE> (A) Cash basis financial data exclude intangible assets and the related amortization expense NET INTEREST INCOME Tax equivalent net interest income totaled $13,336,000 during the three months ended March 31, 1999. The 10% increase from $12,112,000 during the comparable period of 1998 is principally the result of an increase in average earning assets. NET INTEREST INCOME AND SELECTED RATIOS <TABLE> <CAPTION> Three months ended March 31, 1999 1998 ----------- ----------- <S> <C> <C> Average earning assets (in thousands) $980,678 $913,329 Tax equivalent net interest income 13,336 12,112 As a percent of average earning assets Tax equivalent interest income 9.09 % 9.30 % Interest expense 3.63 3.98 Tax equivalent net interest income 5.46 5.32 Average earning assets as a percent of average assets 92.22 % 93.27 % Free-funds ratio 10.71 % 9.82 % </TABLE> Average earning assets totaled $980.7 million and $913.3 million during the three months ended March 31, 1999 and 1998, respectively. The 7% increase in average earning assets was principally funded with deposits, excluding Brokered CDs ("Core Deposits"). Such Core 14
16 Deposits averaged $768.0 million and $687.7 million during the three months ended March 31, 1999 and 1998, respectively. (See "Liquidity and capital resources.") Tax equivalent net interest income as a percent of average earnings assets ("Net Yield") was 5.46% during the three-month period in 1999 compared to 5.32% during the comparable period in 1998. The 14 basis point increase in Net Yield principally reflects an increase in Core Deposits as a percentage of average earning assets. Core Deposits were equal to 78.3% and 75.3% of average earning assets for the three months ended March 31, 1999 and 1998, respectively. PROVISION FOR LOAN LOSSES The provision for loan losses was $525,000 during the three months ended March 31, 1999, compared to $633,000 during the three-month period in 1998. The decrease in the provision reflects Management's assessment of the allowance for loan losses based upon the composition of the loan portfolio, an evaluation of specific credits, historical loss experience as well as the level of non-performing and impaired loans. (See "Asset quality.") NON-INTEREST INCOME Non-interest income totaled $3,691,000 during the three months ended March 31, 1999, compared to $2,628,000 during the comparable period in 1998. The $1,063,000 increase in non-interest income principally reflects increases in net gains on the sale of real estate mortgage loans and revenues associated with First Home Financial, Inc. An increase in service charges on deposit accounts, real estate mortgage service fees and mutual fund and annuity commissions also contributed to the increase in non-interest income. NON-INTEREST INCOME <TABLE> <CAPTION> Three months ended March 31, 1999 1998 --------------- -------------- <S> <C> <C> Service charges on deposit accounts $1,038,000 $ 823,000 Net gains on asset sales Real estate mortgage loans 1,248,000 907,000 Securities 14,000 137,000 First Home Financial 426,000 Title insurance fees 185,000 196,000 Real estate mortgage loan servicing 150,000 103,000 Mutual fund and annuity commissions 141,000 22,000 Other 489,000 440,000 ---------- ---------- Total non-interest income $3,691,000 $2,628,000 ========== ========== </TABLE> 15
17 Net gains on the sale of real estate mortgage loans increased to $1,248,000 during the three months ended March 31, 1999, from $907,000 during the comparable period in 1998. Although such net gains increased as a percent of loans sold, the $341,000 increase in such net gains principally reflect the increase in loans sold. <TABLE> <CAPTION> Three months ended March 31 1999 1998 --------------------------------- <S> <C> <C> Real estate mortgage loans originated $96,464,000 $118,830,000 Real estate mortgage loan sales 72,938,000 57,514,000 Real estate mortgage loan servicing rights sold 5,014,000 27,373,000 Net gains on the sale of real estate mortgage loans 1,248,000 907,000 Net gains as a percent of real estate mortgage loans sold 1.71% 1.58% </TABLE> The Banks capitalized approximately $535,000 and $365,000 of related servicing rights during the three-month periods ended March 31, 1999 and 1998, respectively. Amortization of capitalized servicing rights for those periods was $131,000 and $83,000, respectively. The fair value of capitalized servicing rights approximated the book value of $2,479,000 at March 31, 1999, and therefore, no valuation allowance was considered necessary. The capitalized servicing rights relate to approximately $382 million of loans sold and serviced at March 31, 1999. The volume of loans sold is dependent upon the Banks' ability to originate real estate mortgage loans as well as the demand for fixed-rate obligations and other loans that the Banks cannot profitably fund within established interest-rate risk parameters. (See "Asset/liability management.") Net gains on real estate mortgage loans are also dependent upon economic and competitive factors as well as the Banks' ability to effectively manage exposure to changes in interest rates. Given the $10.2 million decline in loans held for sale, together with the absence of substantial refinance activity, net gains on the sale of real estate mortgage loans during subsequent periods may not be commensurate with the amount recorded during the three months ended March 31, 1999. On April 17, 1998, the Registrant purchased the outstanding capital stock of First Home Financial, Inc. ("FHF"), an originator of manufactured home loans. FHF's revenues during the three months ended March 31, 1999, totaled $426,000 and account for 40% of the $1,063,000 increase in other non-interest income. NON-INTEREST EXPENSE Non-interest expense totaled $12,146,000 during the three months ended March 31, 1999, compared to $10,331,000 during the comparable period in 1998. Costs associated with the operation of FHF as well as direct mail marketing costs related to deposit account promotions account for approximately 30% of increase in non-interest expense. Costs associated with the operation of new branch facilities also contributed to the increase in non-interest expense. 16
18 NON-INTEREST EXPENSE <TABLE> <CAPTION> Three months ended March 31, 1999 1998 --------------- -------------- <S> <C> <C> Salaries $ 4,395,000 $ 3,708,000 Performance-based compensation and benefits 1,269,000 1,304,000 Other benefits 1,146,000 899,000 ----------- ----------- Salaries and benefits 6,810,000 5,911,000 Occupancy, net 870,000 699,000 Furniture and fixtures 745,000 579,000 Computer processing 570,000 404,000 Amortization of intangible assets 442,000 379,000 Communications 462,000 383,000 Advertising 551,000 386,000 Supplies 323,000 289,000 Loan and collection 389,000 254,000 Other 984,000 1,047,000 =========== =========== Total non-interest expense $12,146,000 $10,331,000 =========== =========== </TABLE> PROPOSED ACQUISITION On March 24, 1999, the Registrant announced that it had signed a definitive agreement to acquire Mutual Savings Bank f.s.b. ("MSB"). As a result of the transaction, the Registrant will issue 0.80 shares of its common stock for each share of MSB common stock, subject to certain adjustments. The transaction is structured as a tax-free exchange of shares and is expected to qualify as a "pooling-of-interests". The transaction is subject to approval by the shareholders of both companies as well as regulatory agencies. The transaction is expected to be consummated in the third quarter of 1999. The Registrant anticipates approximately $5.0 million of one-time, pretax, merger related charges. The merger agreement contains a provision, which allows MSB the right to terminate the transaction if the average price of the Registrant's common stock falls below certain pre-determined levels prior to consummation of the transaction. The merger agreement also provides the Registrant with an option to purchase 19.9% of the outstanding shares of MSB's common stock under certain specified circumstances. At March 31, 1999, MSB had assets of $569 million, deposits of $424 million, shareholder's equity of $36.7 million and shares outstanding of 4.3 million. It provides banking services through a total of 22 offices and its common stock trades on the Nasdaq Stock Market under the symbol MSBK. YEAR 2000 The Year 2000 issue refers to computer-based operating systems that were originally designed to recognize calendar years by their last two digits ("Year 2000"). The Registrant began preparing its computer-based operating systems for 2000 during 1997 and formed a committee to address such issues. A significant portion of the Registrant's Year 2000 issue relates to its core data processing applications which are provided by a third-party service provider, M&I Data Services. 17
19 The Registrant completed its conversion to M&I Data Services Year 2000 compliant application software in 1998. All other material non-compliant operating systems have been identified and are in the process of being replaced. It is anticipated that the replacement and testing of non-compliant operating systems will be completed during the second quarter of 1999. Costs incurred to date have approximated $1 million, which relate primarily to the replacement of systems and fully depreciated non-compliant personal computer equipment. Management estimates that total costs will not exceed $1.6 million and will not have a material impact on the consolidated financial statements. A substantial portion of these costs represent an acceleration of expenditures to replace or upgrade systems that will become obsolete or otherwise inadequate to meet the Registrant's growing technology needs. While the Registrant is not aware of any Year 2000 problems for which a solution is not available, other unanticipated issues could arise. These unanticipated issues may include the ability to identify and correct all relevant computer code, the availability and cost of trained personnel, the impact of the Year 2000 on our customers and other uncertainties. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. No material changes in the market risk faced by the Registrant has occurred since December 31, 1998. 18
20 Item 6. Exhibits & Reports on Form 8-K (a) Exhibit Number & Description 2. Agreement and Plan of Reorganization between the Registrant and Mutual Savings Bank, f.s.b. dated March 24, 1999 10. Warrant Purchase agreement between Registrant and Mutual Savings Bank, f.s.b. dated March 24, 1999 11. Computation of Earnings per share 27. Financial Data Schedule (b) Reports on Form 8-K During the quarter ended March 31, 1999, there were no reports filed on Form 8-K. 19
21 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 May 14, 1999 By /s/William R. Kohls ------------------------ --------------------------------------- William R. Kohls, Principal Financial Officer Date May 14, 1999 By /s/James J. Twarozynski ------------------------ --------------------------------------- James J. Twarozynski, Principal Accounting Officer 20
22 EXHIBIT INDEX ------------- Exhibit No. Description - ----------- ----------- 2. Agreement and Plan of Reorganization between the Registrant and Mutual Savings Bank, f.s.b. dated March 24, 1999 10. Warrant Purchase agreement between Registrant and Mutual Savings Bank, f.s.b. dated March 24, 1999 11. Computation of Earnings per share 27. Financial Data Schedule 21