Isabella Bank Corporation - 10-Q quarterly report FY

 

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(989) 772-9471

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APPLICABLE ONLY TO CORPORATE ISSUERS:

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IBT BANCORP, INC.
Index to Form 10-Q

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(Dollars in thousands)

See notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(UNAUDITED)
(Dollars in thousands except per share data)

See notes to condensed consolidated financial statements.

See notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(Dollars in thousands)

See notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(Dollars in thousands)

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals with the exception of the fair value reporting election described in Note 6 and the adoption of EITF 06-4 in Note 7) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report for the year ended December 31, 2007.

All amounts other than share and per share amounts have been rounded to the nearest thousand ($000) in this report.

Effective January 1, 2008, the Corporation acquired Greenville Community Financial Corporation (GCFC). The consolidated financial statements include the results of operations of GCFC since January 1, 2008 (see Note 2). Effective March 1, 2008, the Corporation entered into a joint venture with Corporate Title Agency, LLC. The consolidated financial statements include the results of operations from this new entity since March 1, 2008 (see Note 2). Refer to Management’s Discussion and Analysis for further consideration of the impact of these transactions on the condensed consolidated financial statements.

On the opening of business on January 1, 2008, IBT Bancorp, Inc. acquired 100 percent of Greenville Community Financial Corporation (GCFC). As a result of this acquisition, Greenville Community Bank, a wholly owned subsidiary of GCFC, merged with and into Isabella Bank (the “Bank”). Under the terms of the merger agreement, each share of GCFC common stock was automatically converted into the right to receive 0.6659 shares of IBT Bancorp, Inc. common stock and $14.70 per share in cash. Exclusive of the effects of the 10% stock dividend paid February 29, 2008, the Corporation issued 514,809 shares of IBT Bancorp, Inc. common stock valued at $22,652 and paid a total of $11,365 in cash to GCFC shareholders. The total consideration exchanged including the value of the common stock issued, cash paid to shareholders, plus cash paid for $579 in transaction costs resulted in a total purchase price of $34,596. The purchase price was determined using the latest transaction price known to management as of November 27, 2007, the date of the merger agreement. The acquisition of Greenville has increased the overall market share for IBT Bancorp in furtherance of the Bank’s strategic plan to pursue certain acquisitions.

The following table summarizes the estimate of the total purchase price of the transaction as well as adjustments to allocate the purchase price based on the preliminary estimates of fair values of the assets and liabilities of GCFC.

The fair value adjustments are being amortized over two years using the straight line amortization method. The core deposit intangible is being amortized using a 15 year sum-of-the-years’ digits amortization schedule. Goodwill, which is not amortized, is tested for impairment at least annually. As the acquisition was considered a stock transaction, goodwill is not deductible for federal income tax purposes.

The 2008 consolidated statements of income include operating results of GCFC since the date of acquisition.

The unaudited pro forma information presented in the following table has been prepared based on IBT Bancorp’s historical results combined with GCFC. The information has been combined to present the results of operations as if the acquisition had occurred at the beginning of the period presented. The pro forma results are not necessarily indicative of the results which would have actually been attained if the acquisition had been consummated in the past or what may be attained in the future (as adjusted for the 10% stock dividend paid February 29, 2008):

On March 1, 2008, IBT Title and Insurance Agency, Inc., a wholly owned subsidiary of IBT Bancorp, Inc., merged its assets and liabilities with Corporate Title Agency, LLC (“Corporate Title”), a third-party title business based in Traverse City, Michigan, to form CT/IBT Title Agency, LLC. As a result of this transaction, the Corporation became a 50 percent joint venture owner in CT/IBT Title Agency, LLC. The purpose of this joint venture was to help IBT Title and Insurance Agency, Inc. expand its service area and to take advantage of economies of scale. As the Corporation is a 50% owner of this new entity, revenues and expenses will now be recorded under the equity method, and as such net income from the joint venture will be included in other income. As of March 31, 2008, the Corporation had a recorded investment of $7,173 in the new entity, which is included in equity securities without readily determinable fair values. The following table summarizes the balance sheet of IBT Title as of March 1, 2008. These amounts were excluded from the balance sheet detail of the Corporation and are now properly recorded as an investment in equity securities without readily determinable fair values.

Basic earnings per share represents income available to common stockholders divided by the weighted—average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustments to income that would result from the assumed issuance. Potential common shares that may be issued by the Corporation relate solely to outstanding shares in the Corporation’s Deferred Director fee plan.

Earnings per common share have been computed based on the following amounts:

The Corporation’s reportable segments are based on legal entities that account for at least 10% of net operating results. In April 2007, the individual bank charters of Isabella Bank and Trust and FSB Bank were consolidated into one bank charter as a part of the Corporation’s strategy to increase efficiencies. As of March 31, 2008 and 2007, retail banking operations represent approximately 90% or greater of the Corporation’s total assets and operating results. As such, no segment reporting is presented.

The accounting policies are the same as those discussed in Note 1 to the Consolidated Financial Statements included in the Corporation’s annual report for the year ended December 31, 2007, with the addition of new pronouncements adopted during 2008 (see Note 7).

The Corporation has a non-contributory defined benefit pension plan covering substantially all of its employees. In December 2006, the Board of Directors voted to curtail the defined benefit plan effective March 1, 2007. The effect of the curtailment, which was recognized in the first quarter of 2007, suspended the current participants’ accrued benefits as of March 1, 2007 and limited participation in the plan to eligible employees as of December 31, 2006. As a result of the curtailment, the Corporation changed its method of accounting for the plan to be in accordance with SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits. Due to the curtailment, future salary increases will not be considered and the benefits are based on years of service and the employees’ five highest consecutive years of compensation out of the last ten years of service through March 1, 2007. As a result of the curtailment, the Corporation does not anticipate contributing to the plan in the future.

The components of net periodic benefit (income) cost for the three month periods ended March 31 are as follows:

Fair value is the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety.

Level 1 instruments are those assets for which the identical item is traded on an active exchange, such as publicly-traded instruments. The majority of the fair value amounts included in current period earnings resulted from Level 2 fair value methodologies; that is, the Corporation values the assets and liabilities based on observable market data for similar instruments. The Corporation has no assets or liabilities that meet the Level 3 criteria.

During the three month period ended March 31, 2008, in accordance with the provisions of SFAS No. 156, mortgage servicing rights with a carrying amount of $2,185 were written down to their fair value of $2,155, resulting in an impairment charge of $30, while during the same period in 2007, mortgage servicing rights with a carrying amount of $2,187 were written down to their fair value of $2,186, resulting in an impairment charge of $1. Such adjustments were included in earnings for the three month period ended March 31, 2008 and 2007, respectively.

During the three month period ended March 31, 2007, in accordance with the provisions of SFAS No. 144, other real estate owned with a carrying amount of $643 was written down to its fair value less costs to sell of $617, resulting in an impairment charge of $26. This adjustment was included in earnings for the three month period ended March 31, 2007. There were no adjustments to the fair value of other real estate owned during the three month period ended March 31, 2008.

The activity in the trading portfolio for the three month periods ended March 31, 2008 and 2007 was as follows:

The net gain on trading securities, which includes mark-to-market adjustments, totaled $443, of which $430 relates to securities that were held in the Corporation’s trading portfolio as of March 31, 2008.

During the first three months of 2008 and 2007, there were no changes in the level of borrowings measured at fair value, only recurring market value adjustments.

On March 19, 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 161 (SFAS No.161) Disclosures about Derivative Instruments and Hedging Activities. The objective of SFAS No. 161 is to enhance disclosures about an entity’s derivative and hedging activities and thereby improve the transparency of financial reporting. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008 and is not expected to have a significant impact on the Corporation’s consolidated financial statements.

In September of 2006, EITF Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangement, was ratified by the FASB. The EITF reached a consensus that for an endorsement split-dollar life insurance arrangement within the scope of this Issue, an employer should recognize a liability for future benefits. IBT Bancorp has purchased corporation-owned life insurance on certain of its employees. The cash surrender value of these policies is carried as an asset on the condensed consolidated balance sheets. The carrying value was $13,195 at December 31, 2007. These life insurance policies are generally subject to endorsement split-dollar life insurance arrangements. These arrangements were designed to provide a pre-and postretirement benefit for senior officers of the Corporation. The Corporation adopted EITF Issue No. 06-4 effective January 1, 2008 and as a result recorded an initial liability of $2,375. To establish this liability, the Corporation recorded a one time charge of $1,571, net of tax, directly to retained earnings at that date. The periodic policy maintenance costs were $18 for the three months ended March 31, 2008.

The following is management’s discussion and analysis of the major factors that influenced IBT Bancorp’s financial performance. This analysis should be read in conjunction with the Corporation’s 2007 annual report and with the unaudited interim condensed consolidated financial statements and notes, as set forth on pages 3 through 13 of this report.

CRITICAL ACCOUNTING POLICIES: A summary of the Corporation’s significant accounting policies is set forth in Note 1 of the Consolidated Financial Statements included in the Corporation’s Annual Report for the year ended December 31, 2007. Of these significant accounting policies, the Corporation considers its policies regarding the allowance for loan losses and acquisition intangibles to be its most critical accounting policies.

The allowance for loan losses requires management’s most subjective and complex judgment. Changes in economic conditions can have a significant impact on the allowance for loan losses and, therefore, the provision for loan losses and results of operations. The Corporation has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Corporation’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which is not known to management at the time of the issuance of the consolidated financial statements. For additional discussion concerning the Corporation’s allowance for loan losses and related matters, see Provision for Loan Losses and Allowance for Loan Losses in the Corporation’s 2007 Annual Report and herein.

Generally accepted accounting principles require the Corporation to determine the fair value of all of the assets and liabilities of an acquired entity, and record their fair value on the date of acquisition. The Corporation employs a variety of means in determination of the fair value, including the use of discounted cash flow analysis, market comparisons, and projected future revenue streams. For certain items that management believes it has the appropriate expertise to determine the fair value, management may choose to use its own calculations of the value. In other cases, where the value is not easily determined, the Corporation consults with outside parties to determine the fair value of the identified asset or liability. Once valuations have been adjusted, the net difference between the price paid for the acquired company and the value of its balance sheet, including identifiable intangibles, is recorded as goodwill. This goodwill is not amortized, but is tested for impairment on at least an annual basis.

The following table outlines the results of operations for the three month periods ended March 31, 2008 and 2007. Return on average assets measures the ability of the Corporation to profitably and efficiently employ its resources. Return on average equity indicates how effectively the Corporation is able to generate earnings on shareholder invested capital.

Net interest income equals interest income less interest expense and is the primary source of income for IBT Bancorp, Inc. Interest income includes loan fees of $411 for the three month period ended March 31, 2008 as compared to $231 during the same period in 2007. For analytical purposes, net interest income is adjusted to a “taxable equivalent” basis by adding the income tax savings from interest on tax-exempt loans and securities, thus making year-to-year comparisons more meaningful.

(Continued on page 17)

The following schedules present the daily average amount outstanding for each major category of interest earning assets, nonearning assets, interest bearing liabilities, and noninterest bearing liabilities. This schedule also presents an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a fully taxable equivalent (FTE) basis using a 34% tax rate. Nonaccruing loans, for the purpose of the following computations, are included in the average loan amounts outstanding. Federal Reserve and Federal Home Loan Bank restricted equity holdings are included in Other.

Results for the three month periods ended March 31, 2008 and March 31, 2007 are as follows:

The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:

Volume Variance — change in volume multiplied by the previous year’s rate.

Rate Variance — change in the fully taxable equivalent (FTE) rate multiplied by the prior year’s volume.

The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Net interest income as a percentage of earning assets increased 0.32% in the first quarter of 2008 when compared to the same period in 2007. The principal factors affecting this increase were (1) a 2% increase, as a percentage of gross loans, in high yielding commercial loans with a corresponding decrease in residential mortgage loans and (2) the fact that in early 2007 the Corporation extended the maturities of interest earning assets. As interest rates declined in the latter half of 2007, the cost of funding sources decreased more rapidly than the rates earned on interest earning assets.

The yield curve began to correct itself during the third quarter of 2007, primarily as a result of a .50% decrease in the federal funds target rate, as this decrease lowered short term interest rates. The yield curve further corrected itself during the fourth quarter of 2007 and the first quarter of 2008 as a result of further rate cuts by the Fed. In total, the national prime rate has decreased 3.0% since the third quarter of 2007.

The Corporation’s balance sheet is currently well positioned to protect interest margins in a decreasing rate environment. The overall impact on financial performance could be negative if economic conditions in its principal market deteriorate significantly as a result of a material economic downturn.

The total volume and rate variances of $2,001 resulted in net increases in net FTE interest margin of $1,195 related to volume and $806 related to rate, when the three month period ended March 31, 2008 is compared to the same period in 2007.

The viability of any financial institution is ultimately determined by its management of credit risk. Total loans outstanding represent 63.6% of the Corporation’s total assets and is the Corporation’s single largest concentration of risk. The allowance for loan losses is management’s estimation of potential future losses inherent in the existing loan portfolio. Factors used to evaluate the loan portfolio, and thus to determine the current charge to expense, include recent loan loss history, financial condition of borrowers, amount of nonperforming and impaired loans, overall economic conditions, and other factors. The following table summarizes the Corporation’s charge off and recovery activity for the three month periods ended March 31, 2008 and 2007.

The allowance for loan losses as a percentage of loans has decreased from 1.29% as of March 31, 2007 to 1.19% in the first quarter of 2008. The provision for loan losses was increased by $1,081 in 2008. This increase in the provision was the result of the increased level of net loans charged off as well as management’s knowledge of current economic conditions. The Corporation has experienced an increase in foreclosed loans and an increase in charge offs due to the downturn in the real estate mortgage market.

The nationwide increase in residential mortgage loans past due and in foreclosures has received considerable attention by both the media and banking regulators. Based on information provided by The Mortgage Bankers Association, the increases in both past dues and foreclosures are related to fixed and adjustable rate sub-prime mortgages. Additionally, a substantial portion of sub-prime adjustable rate mortgages are scheduled to reset at higher rates in the next 9 months. As a result of the rate resetting on these mortgages, it is expected that troubled sub-prime loans nationally will increase substantially through the end of 2008. While Isabella Bank does not hold sub-prime mortgage loans, the difficulties experienced in the sub-prime market have the potential to adversely impact the entire market, and thus the overall credit quality of the Bank’s residential mortgage portfolio. The increase in troubled residential mortgage loans and a tightening of underwriting standards will most likely result in a continued increase in the inventory of unsold homes. The inventory of unsold homes has not reached these levels since the 1991 recession. The combination of all of these factors will most likely further reduce average home values and thus homeowner’s equity on a national level.

The Corporation originates and sells fixed rate residential real estate mortgages to the Federal Home Loan Mortgage Corporation and US Bank. The Corporation has not originated loans for either trading or its own portfolio that would be classified as sub-prime or financed loans for more than 80% of market value unless insured by private third party insurance.

Due to the aforementioned residential real estate market difficulties being experienced, the Corporation has taken a proactive approach as to when a loan should be placed on nonaccrual status. Residential real estate loans are now placed in nonaccrual status when the foreclosure process has begun, unless there is an abundance of collateral. Additionally, these loans are charged down to their estimated net realizable value when placed on nonaccrual. Historically, residential real estate loans were placed in nonaccrual status upon reaching the beginning of the legally mandated borrower redemption period, which is typically six months. Chargeoffs of any expected deficiency were previously done at the end of the six month redemption period. This proactive approach had a significant impact on the increase in loans classified as nonaccrual and as well as the increase in gross chargeoffs in the first quarter of 2008.

The increase in the Corporation’s nonperforming loans is primarily related to the current market difficulties previously discussed. The majority of the increase in other real estate owned is related to one large loan, in the amount of $670, that was transferred to other real estate owned in December 2007. Based on management’s analysis of the allowance for loan losses, the current allowance falls within the acceptable range and, therefore, the allowance for loan losses is considered adequate as of March 31, 2008.

To management’s knowledge, there are no other loans which cause management to have serious doubts as to the ability of a borrower to comply with their loan repayment terms.

The following discussions of noninterest income and noninterest expenses have been adjusted for the acquisition of Greenville Community Financial Corporation (“GCFC”) on January 1, 2008 to make the line items this quarter more comparable with the prior period numbers.

Noninterest income consists of trust fees, deposit service charges, fees for other financial services, gains on the sale of mortgage loans, title insurance revenue, and other. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations:

As a result of the persistent compression on interest margins, management continuously analyzes various fees related to deposit accounts, including service charges, NSF and overdraft fees, and ATM and debit card fees. Based on these analyses, the Corporation makes any necessary adjustments to ensure that its fee structure is within the range of its competitors, while at the same time making sure that the fees remain fair to deposit customers. Management does not expect significant changes to its deposit fee structure in 2008.

Net originated mortgage servicing rights (OMSR) income includes amortization and impairment charges of $111 and $47 for the three months ended March 31, 2008 and 2007, respectively. These charges, coupled with the decrease in new residential mortgage activity have resulted in the decrease in income related to OMSR. Management believes that that this trend will continue throughout the remainder of 2008.

Title insurance fees have decreased as a result of IBT Title and Insurance Agency’s merger with Corporate Tile on March 1, 2008 (See Note 2 of Notes to Condensed Consolidated Financial Statements), as well as the continued slow activity in real estate mortgage activity.

The increase in net gain on trading securities during the first quarter of 2008 is the result of decreases in interest rates, as there is an inverse relationship between the value of the trading portfolio and changes in interest rates. Offsetting the gains on trading securities were losses on other borrowings carried at fair market value, as there is a direct relationship between the value of these borrowings and changes in interest rates. Management does expect trading gains as well as fair value losses on other borrowed funds to stabilize throughout the remainder of 2008.

The first three months of 2008 have been some of the most productive months in the Corporation’s history for brokerage and advisory services. These results are due to an increase in customer base and a conscious effort by management to expand the Bank’s presence in the local market. The Corporation anticipates this trend to continue throughout the rest of the year.

Losses on sales of available for sale investment securities were incurred by the Corporation in the first quarter of 2007. This was a result of the Corporation selling investments nearing maturity at low interest rates and reinvesting the proceeds in higher yielding

longer term securities as part of asset and liability management. The additional interest income earned upon the reinvestment of the proceeds exceeded the losses recognized in the fourth quarter of 2007.

Noninterest expenses include compensation, occupancy, furniture and equipment, and other expenses. Significant account balances are highlighted in the accompanying tables with additional descriptions of significant fluctuations: