FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended MARCH 31, 1998 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-5907 1st SOURCE CORPORATION (Exact name of registrant as specified in its charter) INDIANA 35-1068133 (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 North Michigan Street South Bend, Indiana 46601 (Address of principal executive offices) (Zip Code) (219) 235-2702 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No Number of shares of common stock outstanding as of March 31, 1998 - 17,353,840 shares. PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements Page Consolidated statements of financial condition -- 3 March 31, 1998, and December 31, 1997 Consolidated statements of income -- 4 three months ended March 31, 1998 and 1997 Consolidated statements of cash flows -- 5 three months ended March 31, 1998 and 1997 Notes to the Consolidated Financial Statements 6 <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION 1st Source Corporation and Subsidiaries (Dollars in thousands) March 31, December 31, 1998 1997 <S> <C> <C> ASSETS Cash and due from banks $ 73,615 $ 90,864 Interest bearing deposits with other banks 793 1,677 Federal funds sold -- 10,000 Investment securities: Securities available-for-sale, at fair value (amortized cost of $312,044 and $298,438 at March 31, 1998 and December 31, 1997) 314,087 299,933 Securities held-to-maturity, at amortized cost (fair value of $114,850 and $119,369 at March 31, 1998 and December 31, 1997) 110,815 114,975 Total Investment Securities 424,902 414,908 Loans - net of unearned discount 1,904,564 1,796,781 Reserve for loan losses (37,674) (35,424) Net Loans 1,866,890 1,761,357 Premises and equipment 30,771 30,782 Other assets 117,654 108,566 Total Assets $ 2,514,625 $2,418,154 LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Non-interest bearing $ 247,459 $ 274,906 Interest bearing 1,684,129 1,616,885 Total Deposits 1,931,588 1,891,791 Federal funds purchased and securities sold under agreements to repurchase 140,487 117,987 Other short-term borrowings 144,299 117,019 Other liabilities 39,147 34,998 Long-term debt 12,659 16,656 Total Liabilities 2,268,180 2,178,451 Guaranteed preferred beneficial interests in the Company's subordinated debentures 44,750 44,750 Shareholders' equity: Common stock-no par value 6,270 5,700 Capital surplus 121,456 69,947 Retained earnings 78,168 124,394 Less cost of common stock in treasury (6,484) (6,978) Unrealized appreciation of investment securities, net 2,285 1,890 Total Shareholders' Equity 201,695 194,953 Total Liabilities and Shareholders' Equity $ 2,514,625 $2,418,154 The accompanying notes are a part of the consolidated financial statements. </TABLE> <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF INCOME 1st Source Corporation and Subsidiaries (Dollars in thousands, except per share amounts) Three Months Ended March 31 1998 1997 <S> <C> <C> Interest Income: Loans, including fees $ 41,772 $ 33,010 Investment securities: Taxable 4,046 4,022 Tax-exempt 1,997 2,034 Other 77 80 Total Interest Income 47,892 39,146 Interest Expense: Deposits 19,984 16,487 Short-term borrowings 4,432 2,670 Long-term debt 232 318 Total Interest Expense 24,648 19,475 Net Interest Income 23,244 19,671 Provision for Loan Losses 2,401 1,229 Net Interest Income After Provision for Loan Losses 20,843 18,442 Non-Interest Income: Trust fees 2,066 1,769 Service charges on deposit accounts 1,406 1,249 Loan servicing and sale income 2,520 1,422 Equipment rental income 2,347 1,156 Other income 2,445 1,384 Investment securities and other gains (losses) (122) 181 Total Non-Interest Income 10,662 7,161 Non-Interest Expense: Salaries and employee benefits 11,687 9,691 Net occupancy expense 1,218 1,172 Furniture and equipment expense 1,642 1,544 Depreciation - leased equipment 1,820 768 Business development and marketing expense 587 493 Other 2,900 2,575 Total Non-Interest Expense 19,854 16,243 Income Before Income Taxes and Subsidiary Trust Distributions 11,651 9,360 Income taxes 3,926 3,235 Distribution on preferred securities of subsidiary trusts, net of tax 565 59 Net Income $ 7,160 $ 6,066 Other Comprehensive Income, Net of Tax: Unrealized Gain (Loss) on Securities 395 (839) Comprehensive Income $ 7,555 $ 5,227 Per Common Share: <F1> Basic Net Income Per Common Share $ 0.41 $ 0.35 Diluted Net Income Per Common Share $ 0.40 $ 0.34 Dividends $ 0.073 $ 0.066 Basic Weighted Average Common Shares Outstanding 17,345,487 17,198,020 Diluted Weighted Average Common Shares Outstanding 17,711,171 17,707,468 <FN> <F1> The computation of per share data gives retroactive recognition to a 10% stock dividend declared on January 20, 1998, and a five-for-four stock split declared on January 21, 1997. </FN> The accompanying notes are a part of the consolidated financial statements. </TABLE> <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF CASH FLOWS 1st Source Corporation and Subsidiaries (Dollars in thousands) Three Months Ended March 31 1998 1997 <S> <C> <C> Operating Activities: Net income $ 7,160 $ 6,066 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 2,401 1,229 Depreciation of premises and equipment 2,730 1,557 Amortization of investment security premiums and accretion of discounts, net 219 226 Deferred income taxes 269 (626) Realized investment securities (gains) losses 122 (181) Increase in interest receivable (909) (585) Increase in interest payable 2,171 2,813 Other (1,186) 548 Net Cash Provided by Operating Activities 12,977 11,047 Investing Activities: Proceeds from sales and maturities of investment securities 38,516 30,481 Purchases of investment securities (48,299) (31,239) Net (decrease) increase in short-term investments 10,885 (648) Loans sold or participated to others 33,679 37,367 Net increase in loans made to customers and principal collections on loans (141,500) (117,033) Net increase in leased assets (4,776) (1,389) Purchases of premises and equipment (604) (859) Other (2,116) (1,206) Net Cash Used in Investing Activities (114,215) (84,526) Financing Activities: Net decrease in demand deposits, NOW accounts and savings accounts (20,016) (14,802) Net increase in certificates of deposit 59,812 3,961 Net (decrease) increase in short-term borrowings 49,780 (8,150) Payments on long-term debt (3,997) (21) Proceeds from issuance of cumulative trust preferred securities 0 42,500 Acquisition of treasury stock (340) (23) Cash dividends (1,262) (1,126) Other 12 (8) Net Cash Provided by Financing Activities 83,989 22,331 Decrease in Cash and Cash Equivalents (17,249) (51,148) Cash and Cash Equivalents, Beginning of Year 90,864 137,588 Cash and Cash Equivalents, End of Period $ 73,615 $86,440 The accompanying notes are a part of the consolidated financial statements. </TABLE> Notes to the Consolidated Financial Statements 1. The unaudited consolidated condensed financial statements have been prepared in accordance with the instructions for Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. The information furnished herein reflects all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods for which this report is submitted. The 1997 1st Source Corporation Annual Report on Form 10-K should be read in conjunction with these statements. 2. 1st Source has adopted Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share," as of December 31, 1997. 1st Source was required to adopt this pronouncement as of December 31, 1997. SFAS No. 128 requires 1st Source to make a dual presentation of basic and fully diluted earnings per share on the face of its consolidated statements of income. The adoption of SFAS No. 128 has not significantly impacted the Company's historically reported earnings per share. 3. 1st Source has adopted Financial Accounting Standard (SFAS) No. 130, "Reporting Comprehensive Income," as of March 31, 1998. SFAS No. 130 establishes standards for the reporting and disclosure of comprehensive income and its components in a full set of general purpose financial statements. Presently, the only component of comprehensive income not included in net income is unrealized gains or losses on available-for-sale investment securities. 4. In June 1997, the Financial Accounting Standards Board issued SFAS No. 131 "Disclosure about Segments of an Enterprise and Related Information." The Statement changes the manner in which public companies report significant information in annual reports and requires companies to report selected segment information in interim financial reports. Companies will be required to report financial and descriptive information about the company's operating segments. In the year of adoption, companies will not be required to disclose interim period information. 1st Source will adopt the Statement in 1998. 5. During 1997, 1st Source raised $44.75 million through the issuance of Cumulative Trust Preferred Securities. 1st Source Capital Trust I issued $27.5 million of 9.00% Cumulative Trust Preferred Securities. 1st Source Capital Trust II issued $17.25 million of floating rate Cumulative Trust Preferred Securities. 1st Source Capital Trust I and 1st Source Capital Trust II are wholly-owned consolidated subsidiaries of the Company. The Holders of the Fixed Rate Preferred Securities are entitled to receive preferential cumulative cash distributions from 1st Source Capital Trust I, at the annual rate of 9.00% of the liquidation amount of $25 per Preferred Security, accruing from the date of original issuance and payable quarterly in arrears on the last day of March, June, September and December of each year. Holders of the Floating Rate Preferred Securities are entitled to receive preferential cumulative cash distributions from 1st Source Capital Trust II, at the annual rate equal to the sum of the 3-Month Treasury adjusted to a constant maturity plus 2.25% applied to the liquidation amount of $25 per Floating Rate Preferred Security accruing from the date of original issuance and payable quarterly in arrears on the last day of March, June, September and December of each year. PART I. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This discussion and analysis should be read in conjunction with the Company's consolidated condensed financial statements and the financial and statistical data appearing elsewhere in this report and the 1997 1st Source Corporation Annual Report on Form 10-K. The amounts shown in this analysis have been adjusted to reflect tax-exempt income on a tax equivalent basis using a 40.525% rate. Management's discussion and analysis contains forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, such performance involves risks and uncertainties which may cause actual results to differ materially from those in such statements. For a discussion of certain factors that may cause such forward-looking statements to differ materially from actual results, see the 1997 Form 10-K. COMPARISON OF THREE-MONTH PERIODS ENDED MARCH 31, 1998 AND 1997 Net income for the three-month period ended March 31, 1998, was $7,160,000 compared to $6,066,000 for the equivalent period in 1997 The primary reasons for the increase were an increase in net interest income and a strong increase in non-interest income offset by an increase in the provision for loan losses and an increase in non-interest expense. Diluted net income per common share increased to $0.40 for the three- month period ended March 31, 1998, from $.34 in 1997. Return on average common shareholders' equity was 14.64% for the three months ended March 31, 1998, compared to 14.10% in 1997. The return on total average assets was 1.19% for the three months ended March 31, 1998, compared to 1.22% in 1997. NET INTEREST INCOME The taxable equivalent net interest income for the three-month period ended March 31, 1998, was $24,153,000, an increase of 17.12% over the same period in 1997, resulting in a net yield of 4.33% compared to 4.43% in 1997. Total average earning assets increased 19.79% for the three-month period ended March 31, 1998, compared to the period ended March 31, 1997. Total average investment securities increased .38% from one year ago, while a 25.53% increase in average loans occurred primarily in transportation and equipment loans. The taxable equivalent yields on total average earning assets were 8.75% and 8.61% for the periods ended March 31, 1998, and 1997 respectively. Average deposits increased 17.81% from the first quarter of 1997 to the first quarter of 1998. The cost rate on average interest-bearing funds was 5.17% for the three-months ended March 31, 1998, compared to 4.88% for the three months ended March 31, 1997. The majority of the growth in deposits from last year has occurred in time deposits of $100 thousand and over and time deposits greater than one year. The following table sets forth consolidated information regarding average balances and rates. <TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Three Months Ended March 31 1998 1997 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 271,221 $ 4,046 6.05% $ 268,132 $ 4,022 6.08% Tax exempt <F1> 148,832 2,855 7.78% 150,335 2,950 7.96% Net loans <F2><F3> 1,837,020 41,823 9.23% 1,463,451 33,045 9.16% Other investments 5,462 77 5.72% 6,762 81 4.83% Total Earning Assets 2,262,535 48,801 8.75% 1,888,680 40,098 8.61% Cash and due from banks 78,492 70,154 Reserve for loan losses (36,113) (29,833) Other assets 143,107 93,595 Total $2,448,021 $2,022,596 LIABILITIES AND SHAREHOLDERS' EQUITY: Interest bearing deposits $1,628,832 $19,984 4.98% $1,389,972 $16,487 4.81% Short-term borrowings 292,933 4,432 6.14% 210,805 2,670 5.14% Long-term debt 13,310 232 7.06% 18,585 318 6.93% Total Interest Bearing Liabilities 1,935,075 24,648 5.17% 1,619,362 19,475 4.88% Non-interest bearing deposits 233,018 190,387 Other liabilities 81,547 38,436 Shareholders' equity 198,381 174,411 Total $2,448,021 $2,022,596 Net Interest Income $24,153 $20,623 Net Yield on Earning Assets on a Taxable Equivalent Basis 4.33% 4.43% <FN> <F1> Interest income includes the effects of taxable equivalent adjustments, using a 40.525% rate for 1998 and 1997. Tax equivalent adjustments were $858 in 1998 and $916 in 1997. <F2> Loan income includes fees of $1,094 in 1998 and $797 in 1997. Loan income also includes the effects of taxable equivalent adjustments, using a 40.525% rate for 1998 and 1997. The tax equivalent adjustments were $51 in 1998 and $36 in 1997. <F3> For purposes of this computation, non-accruing loans are included in the daily average loan amounts outstanding. </FN> </TABLE> PROVISION FOR LOAN LOSSES The provision for loan losses for the three-month periods ended March 31, 1998, and 1997, was $2,401,000 and $1,229,000, respectively. Year-to-date Net Charge-Offs of $151,000 have been recorded in 1998, compared to $259,000 of Net Recoveries for the same period in 1997. The reserve for loan losses was $37,674,000 or 1.98% of net loans at March 31, 1998, compared to $35,424,000 or 1.97% of net loans at December 31, 1997. Non-performing assets at March 31, 1998, were $10,838,000 compared to $11,436,000 at December 31, 1997, a decrease of 5.23%. At March 31, 1998, non-performing assets were .57% of net loans compared to .64% at December 31, 1997. It is management's opinion that the reserve for loan losses is adequate to absorb anticipated losses in the loan portfolio as of March 31, 1998. NON-INTEREST INCOME Non-interest income for the three-month periods ended March 31, 1998, and 1997 was $10,662,000 and $7,161,000, respectively. Trust fees increased 16.79%, service charges on deposit accounts increased 12.57%, loan servicing and sale income increased 77.22%, equipment rental income increased 103.03% and other income increased 76.66%. The loan servicing and sale income increase came from additional aircraft loan securitization servicing and an increase in the sale and servicing of mortgage loans. The significant increase in equipment rental income was primarily due to higher operating lease volume. The growth of other income was generated primarily by increases in cash surrender value of bank-owned life insurance and mortgage underwriting fees. Investment Security and other net losses for the three-month period ended March 31, 1998, were $122,000 compared to net gains of $181,000 in 1997. The net losses in 1998 and the net gains in 1997 were primarily due to adjustments made to the carrying value of certain partnership investments. NON-INTEREST EXPENSE Non-interest expense for the three-month period ended March 31, 1998, was $19,854,000, an increase of 22.23% over the same period in 1997. For the three-month period ended March 31, 1998, salaries and employee benefits increased 20.6%, net occupancy expense increased 3.92%, furniture and equipment expense increased 6.35%, depreciation on leased equipment increased 136.98%, business development and marketing expense increased 19.07%, and miscellaneous other expenses increased 12.62% over the same period in 1997. The increase in depreciation of leased equipment is due to a significant volume increase from the prior year. The primary increase in salaries and employee benefits is attributed to the additional expense provisions being made to fund our stock incentive reserves, due to the increase in the market price of 1st Source stock during the first quarter. The increase in miscellaneous expense is due to a charge for professional computer consulting fees. INCOME TAXES The provision for income taxes for the three-month period ended March 31, 1998, was $3,926,000 compared to $3,235,000 for the comparable period in 1997. The provision for income taxes for the three months ended March 31, 1998, and 1997, is at a rate which management believes approximates the effective rate for the year. The increase was due to increased taxable income in 1998. CAPITAL RESOURCES The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. These guidelines require all banks to maintain a minimum leverage capital ratio of 4.00% for adequately capitalized banks and 5.00% for well-capitalized banks. 1st Source's leverage capital ratio was 9.86% at March 31, 1998. The Federal Reserve Board has established risk-based capital guidelines for U.S. banking organizations. The guidelines established a conceptual framework calling for risk weights to be assigned to on and off-balance sheet items in arriving at risk-adjusted total assets, with the resulting ratio compared to a minimum standard to determine whether a bank has adequate capital. The minimum standard risk-based capital ratios effective in 1996 are 4.00% for adequately capitalized banks and 6.00% for well-capitalized banks for Tier 1 risk-based capital and 8.00% and 10.00%, respectively, for total risk-based capital. 1st Source's Tier 1 risk-based capital ratio on March 31, 1998 was 12.08% and the total risk-based capital ratio was 13.36%. LIQUIDITY AND INTEREST RATE SENSITIVITY Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of liquidity management is to match the sources and uses of funds to anticipated customers' deposits and withdrawals, to anticipate borrowing requirements and to provide for the cash flow needs of 1st Source. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates. Close attention is given to various interest sensitivity gaps and interest spreads. Maturities of rate sensitive assets are carefully maintained relative to the maturities of rate sensitive liabilities and interest rate forecasts. At March 31, 1998, the consolidated statement of financial condition was rate sensitive by $98,853,000 more assets than liabilities scheduled to reprice within one year or 107.80%. Management adjusts the composition of its assets and liabilities to manage the interest rate sensitivity gap based upon its expectations of interest rate fluctuations. 1st Source has entered into two off-balance sheet interest rate swaps as part of its interest rate risk management strategy. The swaps are being used to hedge against the Company's Prime floating rate loans. The notional amount of the first swap as of March 31, 1998, is $23.8 million. It has a maturity date of January, 2002, and has a current fair value of $(52,000). The second swap has a notional amount of $23.4 million as of March 31, 1998. It has a maturity date of March, 2001, and has a current fair value of $13,000. The Company pays a variable interest rate (one-month LIBOR) on each swap and receives a fixed rate. The interest rate swaps are the most efficient means of protecting the bank's net interest rate margin in a declining interest rate environment. Conversely, if interest rates increase, the increased contribution to net interest income from on-balance sheet assets will substantially offset any negative impact on net interest income from these swap transactions. YEAR 2000 During 1997, management formed a task force to analyze the business and operational risks associated with whether systems, software, and other date-specific applications are Year 2000 compliant. Completion of the study, testing and full implementation of any required changes to "mission critical" systems are targeted by December 31, 1998. At this time, management does not anticipate any material impact to 1st Source. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings. None ITEM 2. Changes in Securities. None ITEM 3. Defaults Upon Senior Securities. None ITEM 4. Submission of Matters to a Vote of Security Holders. None ITEM 5. Other Information. None ITEM 6. Exhibits and Reports on Form 8-K. None 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. 1st Source Corporation DATE 5/14/98 /s/ Christopher J. Murphy III (Signature) Christopher J. Murphy III Chairman of the Board and CEO DATE 5/14/98 /s/ Larry E. Lentych (Signature) Larry E. Lentych, Treasurer (Chief Accounting and Financial Officer)