UNITED STATESSECURITIES AND EXCHANGE COMMISSION
(Mark One)
Commission File Number: 000-49733
FIRST INTERSTATE BANCSYSTEM, INC.
(406) 255-5390(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common stock without par value per share
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. þ Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).o Yes þ No
The aggregate market value (appraised minority value) of the registrant’s common stock held by non-affiliates as of the last business day of the registrant’s most recently completed second fiscal quarter, June 30, 2004, was $21,480,375.
The number of shares outstanding of the registrant’s common stock as of January 31, 2005 was 7,966,959.
Documents Incorporated by Reference
The registrant intends to file a definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held May 6, 2005. The information required by Part III of this Form 10-K is incorporated by reference from such Proxy Statement.
PART I
Item 1. Business
The Company
First Interstate BancSystem, Inc. (“FIBS” and collectively with its subsidiaries, the “Company”), incorporated in Montana in 1971, is a financial and bank holding company registered under the Bank Holding Company Act of 1956, as amended. FIBS is headquartered in Billings, Montana. As of December 31, 2004, the Company had assets of $4.2 billion, deposits of $3.3 billion and total stockholders’ equity of $308 million, making it the largest banking organization in Montana and Wyoming.
FIBS’ principal asset is a wholly-owned bank subsidiary, First Interstate Bank (“FIB” or the “Bank”), with 58 banking offices in 30 Montana and Wyoming communities. The Bank, a Montana corporation organized in 1916, delivers a comprehensive range of banking products and services, including demand and savings deposits; commercial, consumer, agricultural and real estate loans; mortgage loan origination and servicing; and, trust, investment and insurance services. The Bank serves individuals, businesses and municipalities throughout its market areas.
The Company also conducts other financial activities through wholly-owned nonbank subsidiaries. The Company’s principal nonbank subsidiaries are as follows. i_Tech Corporation (“i_Tech”) provides technology services to the Bank and other non-affiliated customers in Montana, Wyoming and seven additional states, and provides processing support for 1,983 ATM locations in 35 states. FI Reinsurance, Ltd. (“FIR”), domiciled in Nevis Island, West Indies, was formed in 2001 to underwrite, as reinsurer, credit-related life and disability insurance. First Interstate Statutory Trust (“FIST”) was incorporated under Delaware law in 2003 for the exclusive purpose of issuing capital trust preferred securities and using the proceeds to purchase junior subordinated debentures issued by FIBS.
The Company is the licensee under a trademark license agreement granting it an exclusive, nontransferable license to use the “First Interstate” name and logo in Montana, Wyoming and surrounding states.
Business
The Company derives its income principally from interest charged on loans, and to a lesser extent, from interest and dividends earned on investments. The Company also derives income from noninterest sources such as fees received in connection with various lending and deposit services; trust, investment and insurance services; mortgage loan originations, sales and servicing; merchant and electronic banking services; technology services; and, from time to time, gains on sales of assets. The Company’s principal expenses include interest expense on deposits and borrowings, operating expenses, provisions for loan losses and income tax expense.
Strategic Vision
The banking industry continues to experience change with respect to regulatory matters, consolidation, consumer needs and economic and market conditions. The Company believes it can best address this changing environment through its “Strategic Vision.” The Company’s Strategic Vision is to maintain and enhance its leadership in the financial and social fabric of the communities it serves through a commitment to customer satisfaction, creative management, productive employees and community involvement.
Business Strategy
The Company’s strategy has been to profitably grow its business through internal growth and selective acquisitions. The Company’s focus for 2005 and 2006 includes improving efficiency through a combination of revenue generation and expense saving measures. Long term, the Company continues to look for profitable expansion opportunities in existing and contiguous markets. Much of the Company’s growth in recent years has resulted from opening new banking offices in the Bank’s market areas. During the past five years, the Company has opened nineteen de novo banking offices in Montana and Wyoming and obtained three banking offices through acquisitions.
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Operating Segments
The Company’s operations are managed along two reportable operating segments, Community Banking and Technology Services. The Company’s principal operating segment, Community Banking, encompasses commercial and consumer banking services provided through the Bank, primarily the acceptance of deposits; extensions of credit; mortgage loan origination and servicing; and, trust, investment and insurance services.
The Technology Services operating segment encompasses services provided by i_Tech to affiliated and non-affiliated customers, including core application data processing, ATM and debit card processing, item proof and capture, wide area network services and system support.
For additional information regarding the Company’s operating segments, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations - Operating Segment Results” included in Part II, Item 7 and “Notes to Consolidated Financial Statements — Segment Reporting” included in Part IV, Item 15.
Community Banking
The Company’s banking offices are located in communities of approximately 1,000 to 100,000 people, but serve larger market areas due to the limited number of financial institutions in other nearby communities. The Company believes that the communities served provide a stable core deposit and funding base, as well as economic diversification across a number of industries, including agriculture, energy, mining, timber processing, tourism, government services, education and medical services.
The Company’s community banking philosophy emphasizes providing customers with commercial and consumer banking products and services at a local level using a personalized-service approach and strengthening the communities in the Bank’s market areas through community service activities.
The Company grants significant autonomy to its banking offices in delivering and pricing products at a local level in response to market considerations and customer needs. This autonomy enables the banking offices to remain competitive and enhances the relationships between the banking offices and the customers they serve. The Company also emphasizes accountability, however, by establishing performance and incentive standards that are tied to net income and other success measures at the individual banking office and market level. The Company believes this combination of autonomy and accountability allows the banking offices to provide personalized customer service while remaining attentive to financial performance.
Centralized Services
Certain operational activities have been centralized to provide consistent service levels to customers company-wide, to gain efficiency in management of those activities and to ensure regulatory compliance. Centralized operational activities generally support the Company’s branch banking offices in the delivery of products and services to customers and include marketing, credit review, mortgage loan sales and servicing and other operational activities.
Additionally, FIBS provides centralized policy and management direction and specialized staff support services for the Bank to enable it to serve its markets more effectively. These services include credit administration, finance and accounting, human asset management and other support services.
The Company’s technology subsidiary, i_Tech, provides centralized technology support services to the Bank, including system support of the general ledger, investment security, loan, deposit, web banking, document imaging, management reporting and cash management systems. i_Tech also manages the Company’s wide-area network and the ATM network used by the Bank and provides item proof and capture services. These technology services are performed through the use of computer hardware owned by the Bank and leased to i_Tech and software licensed by i_Tech.
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Lending Activities
FIBS has comprehensive credit policies establishing company-wide underwriting and documentation standards to assist Bank management in the lending process and to limit risk to the Company. The credit policies establish lending authorities based on the experience level and authority of the personnel located in each branch and market. The policies also establish thresholds at which loan requests must be approved by the Company’s credit committee and/or the Bank’s board of directors.
The Bank offers short and long-term real estate, consumer, commercial, agricultural and other loans to individuals and businesses in its market areas. While each loan must meet minimum underwriting standards established in the Company’s credit policies, lending officers are granted certain levels of autonomy in approving and pricing loans to assure that the banking offices are responsive to competitive issues and community needs in each market area.
Real Estate Loans. The Bank provides interim and permanent financing for both single-family and multi-unit properties, medium-term loans for commercial, agricultural and industrial property and/or buildings and equity lines of credit secured by real estate. Residential real estate loans are generally sold in the secondary market. Those residential real estate loans not sold are typically secured by first liens on the financed property and generally mature in less than 15 years. Commercial, agricultural and industrial loans are generally secured by first liens on income-producing real estate and generally mature in less than five years.
Consumer Loans. The Bank’s consumer loans include personal loans, credit card loans and equity lines of credit. Personal loans are generally secured by automobiles, boats and other types of personal property and are made on an installment basis. Credit cards are offered to individual and business customers in the Company’s market areas. Equity lines of credit are generally floating rate loans secured by personal property. Approximately 53% of the Company’s consumer loans are indirect dealer paper that is created when the Company purchases consumer loan contracts advanced for the purchase of automobiles, boats and other consumer goods from consumer product dealers.
Commercial Loans. The Bank provides a mix of variable and fixed rate commercial loans. The loans are typically made to small and medium-sized manufacturing, wholesale, retail and service businesses for working capital needs and business expansions. Commercial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with business operations as the primary source of repayment, but also include collateralization by inventory, accounts receivable, equipment and/or personal guarantees.
Agricultural Loans. The Bank’s agricultural loans generally consist of short and medium-term loans and lines of credit that are generally used for crops, livestock, equipment and general operating purposes. Agricultural loans are generally secured by assets such as livestock or equipment and are repaid from the operations of the farm or ranch. Agricultural loans generally have maturities of five years or less, with operating lines for one production season.
For additional information about the Company’s loan portfolio, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Loans.”
Funding Sources
The Bank offers traditional depository products including checking, savings and time deposits. Additional funding sources include federal funds purchased for one day periods; repurchase agreements with primarily commercial depositors; time deposits brokered outside the Company’s market areas; and, short-term borrowings from the Federal Home Loan Bank of Seattle (“FHLB”). Deposits at the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to statutory limits.
Under repurchase agreements, the Company sells investment securities held by the Company to a customer under an agreement to repurchase the investment securities at a specified time or on demand. The Company does not, however, physically transfer the investment securities. As of December 31, 2004, all outstanding repurchase agreements were due in one day.
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For additional information on the Banks’ funding sources, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Deposits,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Other Borrowed Funds,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Federal Funds Purchased and Securities Sold Under Repurchase Agreements,” included in Part II, Item 7.
Competition
Commercial banking is highly competitive. The Bank competes with other commercial banks for deposits, loans, trust, investment and insurance accounts; and, with savings and loan associations, savings banks and credit unions for deposits and loans. In addition, the Bank competes with other institutions including personal loan companies, mortgage banking companies, finance companies, insurance companies, securities firms, mutual funds and certain government agencies as well as major retailers, all actively engaged in providing various types of loans and other financial services.
While historically the technology services industry has been highly decentralized, there is an accelerating trend toward consolidation resulting in fewer companies competing over larger geographic regions. i_Tech’s competitors vary in size and include national, regional and local operations.
Employees
At December 31, 2004, the Company employed 1,574 full-time equivalent employees. None of the Company’s employees are covered by a collective bargaining agreement. The Company considers its employee relations to be good.
Regulation and Supervision
Financial holding companies and commercial banks are subject to extensive regulation under both federal and state law. Set forth below is a summary description of certain laws that relate to the regulation of FIBS and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
First Interstate BancSystem, Inc.
As a bank and financial holding company, FIBS is subject to regulation under the Bank Holding Company Act of 1956, as amended, and to supervision and regulation by the Federal Reserve.
Under Federal Reserve regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the Federal Reserve’s policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both.
FIBS is required to obtain the prior approval of the Federal Reserve for the acquisition of 5% or more of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve is also required for the merger or consolidation of FIBS and another bank holding company.
Under the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”), FIBS, as a financial holding company, may engage in certain business activities that are determined by the Federal Reserve to be financial in nature or incidental to financial activities as well as all activities authorized to bank holding companies generally. In most circumstances, FIBS must notify the Federal Reserve of its financial activities within a specified time period following its initial engagement in each business or activity. If the type of proposed business or activity has not been previously determined by the Federal Reserve to be financially related or incidental to financial activities, FIBS must receive the prior approval of the Federal Reserve before engaging in the activity.
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FIBS may engage in authorized financial activities provided that it remains a financial holding company and meets certain regulatory standards of being well-capitalized and well-managed. If FIBS fails to meet the well-capitalized or well-managed regulatory standards, it may be required to cease its financial holding company activities or, in certain circumstances, to divest of the Bank. FIBS does not currently engage in significant financial holding company businesses or activities not otherwise permitted to bank holding companies generally.
Under the GLB Act, if FIBS engages in certain financial activities currently authorized to financial holding companies, FIBS, or its affiliates, may become subject to additional laws and regulations relating to the particular activity, such as certain state and federal securities laws and regulations. FIBS may also become subject to supervision or examination by additional regulatory authorities granted regulatory authority over the activity under the GLB Act, such as the Securities and Exchange Commission (“SEC”) or state securities regulatory authorities.
The Bank
The Bank is subject to numerous laws and regulations generally applicable to financial institutions and financial services. The extensive regulation of the Bank limits both the activities in which the Bank may engage and the conduct of the permitted activities. Further, the laws and regulations impose reporting and information collection obligations on the Bank. The Bank incurs significant costs relating to compliance with the various laws and regulations and the collection and retention of information.
The Bank is subject to the supervision of and regular examination by the Federal Reserve, the State of Montana, Division of Banking and Financial Institutions and, with respect to its activities in Wyoming, the State of Wyoming, Department of Audit. If any of the foregoing regulatory agencies determine that the financial condition, capital resources, asset quality, earning prospects, management, liquidity or other aspects of a bank’s operations are unsatisfactory or that a bank or its management is violating or has violated any law or regulation, various remedies are available to such agencies. These remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of a bank, to assess civil monetary penalties, to remove officers and directors and to terminate a bank’s deposit insurance, which would result in a revocation of a bank’s charter. The Bank has not been the subject of any such actions by regulatory agencies.
The FDIC insures the deposits of the Bank in the manner and to the extent provided by law. For this protection, the Bank pays a semiannual statutory assessment. See “Premiums for Deposit Insurance” below. The Bank is subject to the Federal Deposit Insurance Act (“FDIA”) and FDIC regulations relating to the deposit insurance. The Bank may also be subject to supervision and examination by the FDIC, in addition to the regular supervision and examination by the Bank’s primary state and federal banking regulators.
Restrictions on Transfers of Funds to FIBS and the Bank
Large portions of FIBS’ revenues are, and will continue to be, dividends paid by the Bank. The Bank is limited, under both state and federal law, in the amount of dividends that may be paid from time to time. In general, the Bank is limited, without the prior consent of its state and federal banking regulators, to paying dividends that do not exceed the current year net profits together with retained earnings from the two preceding calendar years.
A state or federal banking regulator may impose, by regulatory order or agreement of the Bank, specific regulatory dividend limitations or prohibitions in certain circumstances. The Bank is not subject to a specific regulatory dividend limitation other than generally applicable limitations. In addition to regulatory dividend limitations, the Bank dividends are, in certain circumstances, limited by covenants in FIBS’ debt instruments.
Financial and other transactions between the Bank and FIBS or any FIBS affiliate are also limited under applicable state and federal law. Among other things, the Bank may not lend funds to, or otherwise extend credit to or for the benefit of, FIBS or FIBS affiliates, except on specified types and amounts of collateral and other terms required by state and federal law. In addition, the Federal Reserve has authority to define and limit, from time to time, the transactions between banks and their affiliates. The Federal Reserve issued Regulation W, which became effective April 1, 2003. Regulation W imposes significant additional limitations on transactions in which the Bank may engage with FIBS or FIBS affiliates in addition to the limits under the federal statutes.
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Effect of Government Policies and Legislation
Banking depends on interest rate differentials. In general, the difference between the interest rate paid by the Bank on deposits and borrowings and the interest rate received by the Bank on loans extended to customers and on investment securities comprises a major portion of the Bank’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and potential growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve. The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States government securities, by adjusting the required level of reserves for financial institutions subject to the Federal Reserve’s reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
From time to time, legislation is enacted which has the effect of imposing additional operating restrictions and increasing the cost of doing business, as has been the case with recently enacted laws regarding anti-terrorism and consumer privacy. New legislation may also limit or expand permissible activities or affect the competitive balance between banks and other financial service providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial service providers are frequently made in Congress, in the Montana and Wyoming legislatures and before various bank regulatory and other professional agencies. The likelihood of major legislative changes and the impact such changes might have on FIBS or the Bank are impossible to predict.
Capital Standards
The federal banking agencies have adopted minimum capital requirements for insured banks that are applicable to the Bank. In addition, the Federal Reserve has adopted minimum capital requirements that are applicable to FIBS. The capital requirements are intended to, among other things, provide a means for evaluating the capital adequacy and soundness of the institutions. The federal banking agencies may also set higher capital requirements for particular institutions in specified circumstances under federal laws and regulations.
At December 31, 2004, the Bank and FIBS each met the “well-capitalized” requirements applicable to the respective institution. The “well-capitalized” standard is the highest level of the minimum capital requirements established by the federal agencies. Neither the Bank nor FIBS is subject to a minimum capital requirement other than those applicable to banks or bank holding companies generally.
For more information concerning the capital ratios of FIBS, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition - Capital Resources and Liquidity Management” and “Notes to Consolidated Financial Statements - Regulatory Capital” included in Part IV, Item 15.
Compliance and Safety and Soundness Standards
The federal banking agencies have adopted guidelines establishing standards for safety and soundness, asset quality and earnings, as required by the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”). These standards are designed to identify potential concerns and ensure that action is taken to address those concerns before they pose a risk to the deposit insurance fund. If a federal banking agency determines that an institution fails to meet any of these standards, the agency may require the institution to submit an acceptable plan to achieve compliance with the standard. If the institution fails to submit an acceptable plan within the time allowed by the agency or fails in any material respect to implement an accepted plan, the agency must, by order, require the institution to correct the deficiency.
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Premiums for Deposit Insurance
Deposits in the Bank are insured by the FDIC in accordance with the FDIA. Insurance premiums are assessed semiannually by the FDIC at a level sufficient to maintain the insurance reserves required under the FDIA and relevant regulations. The insurance premium charged to a bank is determined based upon risk assessment criteria, including relevant capital levels, results of bank examinations by state and federal regulators and other information. The Bank currently is assessed the most favorable deposit insurance premiums under the risk-based premium system.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities or in authorizing expansion activities by the Bank and FIBS.
In connection with its assessment of CRA performance, the appropriate bank regulatory agency assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank received an “outstanding” rating on its most recent examination.
Risk Factors
Readers should consider carefully the following factors in evaluating the Company and its business.
Asset Quality
A significant source of risk for the Company arises from the possibility that losses will be sustained by the Bank because borrowers and guarantors may fail to perform in accordance with the terms of their loans. These loans may be unsecured or secured, depending on the nature of the loan. With respect to secured loans, the collateral securing the repayment of these loans includes a wide variety of diverse real and personal property which may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. The Company has adopted underwriting and credit monitoring procedures and policies, including the establishment and review of the allowance for loan losses, that management believes are appropriate to mitigate the risk of loss by assessing the likelihood of nonperformance and the value of available collateral, monitoring loan performance and diversifying the Company’s credit portfolio. Such policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business — Lending Activities” above.
Interest Rate Risk
Banking companies’ earnings depend largely on the relationship between the yield on earning assets, primarily loans and investments, and the cost of funds, primarily deposits and borrowings. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest earning assets and interest bearing liabilities and the level of non-performing assets. Fluctuations in interest rates affect the demand of customers for the Company’s products and services. The Company is subject to interest rate risk to the degree that its interest bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than its interest earning assets. Significant fluctuations in interest rates could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Asset Liability Management — Interest Rate Risk.”
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Changes in the Value of Goodwill and Mortgage Servicing Rights
Under current accounting standards, the Company is not required to amortize goodwill but rather must evaluate goodwill for impairment at least annually. If deemed impaired at any point in the future, an impairment charge representing all or a portion of goodwill will be recorded to current earnings in the period in which the impairment occurred. The capitalized value of net mortgage servicing rights is amortized to earnings over the period of estimated servicing income. Mortgage servicing rights are also subject to periodic impairment reviews. If they are deemed impaired at any point in the future, an impairment charge will be recorded to current earnings in the period in which the impairment occurred. Impairment related to mortgage servicing rights may be reversed if the market value of the mortgage servicing rights recovers. For additional information regarding goodwill and mortgage servicing rights, see “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
Breach of Information Security and Technology Dependence
The Company depends upon data processing, software, communication and information exchange on a variety of computing platforms and networks and over the internet. Despite instituted safeguards, the Company cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Company’s wholly-owned subsidiary, i_Tech, provides technology services to the Bank and other non-affiliated customers. In addition, the Company relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Company could be exposed to claims from customers. Any of these results could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Economic Conditions; Limited Geographic Diversification
The Company’s banking operations are located in Montana and Wyoming. As a result of the geographic concentration of its operations, the Company’s results depend largely upon economic conditions in these areas. Although markets served by the Company are economically diverse, a deterioration in economic conditions could adversely impact the quality of the Company’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Ability of the Company to Execute Its Business Strategy
The financial performance and profitability of the Company will depend on its ability to execute its business strategy and manage its future growth. Although the Company believes that it has substantially integrated recently acquired banks into the Company’s operations, there can be no assurance that unforeseen issues relating to the assimilation or prior operations of these banks, including the emergence of any material undisclosed liabilities, will not materially adversely affect the Company. In addition, any future acquisitions or other future growth may present operating and other problems that could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. The Company’s financial performance will also depend on the Company’s ability to maintain profitable operations through implementation of its Strategic Vision. Moreover, the Company’s future performance is subject to a number of factors beyond its control, including pending and future federal and state banking legislation, regulatory changes, unforeseen litigation outcomes, inflation, lending and deposit rate changes, interest rate fluctuations, increased competition and economic conditions. Accordingly, there can be no assurance that the Company will be able to continue the growth or maintain the level of profitability it has recently experienced.
Dependence on Key Personnel
The Company’s success depends to a significant extent on the management skills of its existing executive officers and directors, many of whom have held officer and director positions with the Company for many years. The loss or unavailability of any of its key executives or directors, including Thomas W. Scott, Chairman of the Board of Directors, Lyle R. Knight, President and Chief Executive Officer, Terrill R. Moore, Executive Vice President and Chief Financial Officer, or Ed Garding, Executive Vice President and Chief Credit Officer, could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See Part III, Item 10, “Directors and Executive Officers of the Registrant.”
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National competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. Moreover, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the GLB Act have increased competition in the financial services industry and in the Bank’s markets, including competition from larger, multi-state financial holding companies and their bank and nonbank affiliates. There can be no assurance that the Company will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business — Competition” and “Business — Regulation and Supervision” above.
Government Regulation and Monetary Policy
The Company and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Company conducts its banking business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit holders of the Company’s securities. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Company. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company, and any unfavorable change in these conditions could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business — Regulation and Supervision” above.
Control by Affiliates
The directors and executive officers of the Company beneficially own 60.9% of the outstanding common stock of the Company. Many of these directors and executive officers are members of the Scott family, which collectively owns 77.5% of the outstanding common stock. By virtue of such ownership, these affiliates are able to control the election of directors and the determination of the Company’s business, including transactions involving any merger, share exchange, sale of assets outside the ordinary course of business and dissolution.
Lack of Trading Market; Market Prices
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 90.7% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 9.3% without such restrictions. FIBS has a right of first refusal to repurchase the restricted stock at fair market value currently determined as the minority appraised value per share based upon the most recent quarterly appraisal available to FIBS. Additionally, restricted stock held by officers, directors and employees of the Company may be called by the Company under certain conditions. All stock not subject to such restrictions may be sold at a price per share that is acceptable to the shareholder. FIBS has no obligation to purchase restricted or unrestricted stock, but has historically purchased such stock. During 2004, the Company repurchased 12,577 shares of its unrestricted stock from participants in the Savings and Profit Sharing Plan for Employees of First Interstate BancSystem, Inc. (“Savings Plan”) and 81,804 shares of its restricted stock from shareholders. All shares were repurchased at the most recent minority appraised value at the repurchase date.
The appraised minority value of FIBS common stock represents the estimated fair market valuation of a minority interest in such stock, taking into account adjustments for the lack of marketability of the stock and other factors. This value does not represent an actual trading price between a willing buyer and seller of the FIBS common stock in an informed, arm’s-length transaction. As such, the appraised minority value is only an estimate as of a specific date, and there can be no assurance that such appraisal is an indication of the actual value holders of FIBS common stock may realize with respect to shares held by them. Moreover, the estimated fair market value of the FIBS common stock may be materially different at any date other than the valuation dates.
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FIBS has no obligation, by contract, policy or otherwise to purchase stock from any shareholder desiring to sell or to create any market for the stock. Historically, it has been the practice of FIBS to repurchase common stock to maintain a shareholder base with restrictions on sale or transfer of the stock. In the last three calendar years (2002-2004), FIBS repurchased a total of 239,413 shares of common stock, 185,872 of which were restricted by shareholder agreements. FIBS repurchased the stock at the most recent appraised minority value at the repurchase date, in accordance with the shareholder agreements. FIBS’ repurchases of stock are subject to corporate law and regulatory restrictions that could prevent stock repurchases. See also Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
Website Access to United States Securities and Exchange Commission Filings
All reports filed electronically by the Company with the SEC, including the annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as amendments to those reports, are accessible at no cost through the Company’s website at www.firstinterstatebank.com as soon as reasonably practicable after they have been filed with the SEC. These reports are also accessible on the SEC’s website at www.sec.gov.
Item 2. Properties
The Company’s principal executive offices and a banking office are anchor tenants in a commercial building located in Billings, Montana. The building is owned by a joint venture partnership in which the Bank is one of two partners, owning a 50% interest in the partnership. As of December 31, 2004, the Company leased approximately 83,023 square feet of space in the building.
As of December 31, 2004, the Company also provided banking services at 57 additional locations in Montana and Wyoming, of which 30 locations are owned by the Company and 27 locations are leased from independent third parties.
The Company leases approximately 24,368 square feet of office space for its operations center, also located in Billings, Montana, and an aggregate of approximately 53,729 square feet of office space in Montana, Colorado, Idaho and Oregon for its technology services subsidiary.
The Company believes its facilities are adequate to meet its needs for at least the next twelve months.
Item 3. Legal Proceedings
In the normal course of business, the Company is named or threatened to be named as a defendant in various lawsuits. In the opinion of management, following consultation with legal counsel, the pending lawsuits are without merit or, in the event the plaintiff prevails, the ultimate liability or disposition thereof will not have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2004.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities
Description of FIBS Capital Stock
The authorized capital stock of FIBS consists of 20,000,000 shares of common stock without par value, of which 7,970,300 shares were outstanding as of December 31, 2004, and 100,000 shares of preferred stock without par value, none of which were outstanding as of December 31, 2004.
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Common Stock
Each share of the common stock is entitled to one vote in the election of directors and in all other matters submitted to a vote of shareholders. Accordingly, holders of a majority of the shares of common stock entitled to vote in any election of directors may elect all of the directors standing for election if they choose to do so, subject to the rights of the holders of the preferred stock. Voting for directors is noncumulative.
Subject to the preferential rights of any preferred stock that may at the time be outstanding, each share of common stock has an equal and ratable right to receive dividends when, if and as declared by the Board of Directors out of assets legally available therefor. In the event of a liquidation, dissolution or winding up of the Company, the holders of common stock will be entitled to share equally and ratably in the assets available for distribution after payments to creditors and to the holders of any preferred stock that may at the time be outstanding. Holders of common stock have no conversion rights or preemptive or other rights to subscribe for any additional shares of common stock or for other securities. All outstanding common stock is fully paid and non-assessable.
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 90.7% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 9.3% held by 17 shareholders without such restrictions, including the Company’s 401(k) plan which holds 79.4% of the unrestricted shares. See also Part I, Item 1, “Risk Factors — Lack of Trading Market; Market Prices.”
Quarter-end minority appraisal values for the past two years, determined by Alex Sheshunoff & Co. Investment Banking, are as follows:
As of December 31, 2004, options for 781,661 shares of the FIBS common stock were outstanding at various exercise prices, ranging from $40.00 to $54.50. The aggregate cash proceeds to be received by FIBS upon exercise of all options outstanding at December 31, 2004, would be $34.2 million, or a weighted average exercise price of $43.74 per share.
Resale of FIBS stock may be restricted pursuant to the Securities Act of 1933 and applicable state securities laws. In addition, most shares of FIBS stock are subject to shareholder’s agreements:
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Purchases of FIBS common stock made through the Company’s Savings Plan are not restricted by Shareholder Agreements, due to requirements of the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code. However, since the Savings Plan does not allow distributions “in kind,” any distributions from an employee’s account in the Savings Plan will allow, and may require, the Financial Services division of the Bank (the “Plan Trustee”), to sell the FIBS stock. While FIBS has no obligation to repurchase the stock, it is likely that FIBS will repurchase FIBS stock sold by the Savings Plan. Any such repurchases would be upon terms set by the Plan Trustee and accepted by FIBS.
There are 688 record shareholders of FIBS as of December 31, 2004, including the Company’s Savings Plan as trustee for 588,370 shares held on behalf of 1,462 individual participants in the plan. Of such participants, 307 individuals also own shares of FIBS stock outside of the plan. The Plan Trustee votes the shares based on the instructions of each participant. In the event the participant does not provide the Plan Trustee with instructions, the Plan Trustee votes those shares in accordance with voting instructions received from a majority of the participants in the plan.
Dividends
It is the policy of FIBS to pay a dividend to all common shareholders quarterly. Dividends are declared and paid in the month following the calendar quarter. The dividend amount is periodically set by the FIBS Board of Directors. The FIBS Board of Directors has no current intention to change its dividend policy, but no assurance can be given that the Board may not, in the future, change or eliminate the payment of dividends.
Historical quarterly dividends for 2003 and 2004 are as follows:
Dividend Restrictions
For a description of restrictions on the payment of dividends, see Item 1, “Business - Regulation and Supervision — Restrictions on Transfers of Funds to FIBS and the Bank.”
Preferred Stock
The authorized capital stock of FIBS includes 100,000 shares of preferred stock. The FIBS Board of Directors is authorized, without approval of the holders of common stock, to provide for the issuance of preferred stock from time to time in one or more series in such number and with such designations, preferences, powers and other special rights as may be stated in the resolution or resolutions providing for such preferred stock. The FIBS Board of Directors may cause FIBS to issue preferred stock with voting, conversion and other rights that could adversely affect the holders of the common stock or make it more difficult to effect a change of control of the Company.
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Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information as of December 31, 2004, regarding the Company’s equity compensation plans.
Equity Compensation Plans
Sales of Unregistered Securities
During 2004, the Company issued 15,732 unregistered shares of its common stock to 142 senior officers, including 10,000 shares pursuant to the Company’s 2004 Restricted Stock Award Plan, and 5,732 shares pursuant to incentive bonuses. The shares were valued at an aggregate of $795,234. These issuances were made in reliance upon the “no sale” provision of Section 2(a)(3) of the Securities Act of 1933, and upon the exemption from registration (to the extent applicable) under Section 4(2) of the Securities Act of 1933.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table provides information with respect to purchases made by or on behalf of the Company or any “affiliated purchasers” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Company’s common stock during the three months ended December 31, 2004.
Purchases of Equity Securities by Issuer
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Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data with respect to the Company’s consolidated financial position as of December 31, 2004 and 2003, and its results of operations for the fiscal years ended December 31, 2004, 2003 and 2002, has been derived from the audited consolidated financial statements of the Company included in Part IV, Item 15. This data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and such consolidated financial statements, including the notes thereto. The selected consolidated financial data with respect to the Company’s consolidated financial position as of December 31, 2002, 2001 and 2000, and its results of operations for the fiscal years ended December 31, 2001 and 2000, has been derived from the audited consolidated financial statements of the Company not included herein.
Five Year Summary
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Five Year Summary (continued)
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Certain statements contained in this document that are not statements of historical fact constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “believes,” “anticipates,” “expects,” “intends,” “plans” and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates; demographic changes; competition; fluctuations in interest rates; changes in business strategy or development plans; changes in governmental regulation; credit quality; the availability of capital to fund the expected expansion of the Company’s business; and, other factors referenced in this document, including, without limitation, information under the caption “Business — Risk Factors” in Part I, Item 1. Given these uncertainties, shareholders and prospective investors are cautioned not to place undue reliance on such forward-looking statements. Forward-looking statements speak only as of the date on which such statements are made. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.
Critical Accounting Estimates and Significant Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. The Company’s significant accounting policies are summarized in “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
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The Company’s critical accounting estimates are summarized below. Management considers an accounting estimate to be critical if: 1) the accounting estimate requires management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain, and 2) changes in the estimate that are reasonably likely to occur from period to period, or the use of different estimates that management could have reasonably used in the current period, would have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.
Allowance for Loan Losses
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements, including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. The allowance for loan losses is maintained at an amount the Company believes is sufficient to provide for estimated losses inherent in its loan portfolio at each balance sheet date. Management continuously monitors qualitative and quantitative trends in the loan portfolio, including changes in the levels of past due, internally classified and non-performing loans. As a result, the Company’s historical experience has provided for an adequate allowance for loan losses. For additional information regarding the allowance for loan losses, its relation to the provision for loan losses and risk related to asset quality, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Provision for Loan Losses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition — Allowance for Loan Losses” below and “Notes to Consolidated Financial Statements — Allowance for Loan Losses” included in Part IV, Item 15.
Valuation of Mortgage Servicing Rights
The Company recognizes as assets the rights to service mortgage loans for others, whether acquired or internally originated. Mortgage servicing rights are initially recorded at fair value and are amortized over the period of estimated servicing income. Mortgage servicing rights are carried on the consolidated balance sheet at the lower of amortized cost or fair value. The Company utilizes the expertise of a third-party consultant to estimate the fair value of its mortgage servicing rights quarterly. In evaluating the mortgage servicing rights, the consultant uses discounted cash flow modeling techniques, which require estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, costs to service, as well as interest rate assumptions that contemplate the risk involved. Management believes the valuation techniques and assumptions used by the consultant are reasonable.
Determining the fair value of mortgage servicing rights is considered a critical accounting estimate because of the assets’ sensitivity to changes in estimates and assumptions used, particularly loan repayment speeds and discount rates. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.
At December 31, 2004, the consultant’s valuation model indicated that an immediate 0.5% decrease in interest rates would result in a reduction in fair value of mortgage servicing rights of $9.3 million and an immediate 1.0% decrease in interest rates would result in a reduction in fair value of $13.5 million.
For additional information regarding mortgage servicing rights, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Mortgage Servicing Rights” included below and “Notes to Consolidated Financial Statements — Mortgage Servicing Rights,” included in Part IV, Item 15.
Executive Overview
FIBS is a financial and bank holding company with 58 banking offices in 30 communities throughout Montana and Wyoming. The Company differentiates itself from competitors by focusing on providing superior service to its banking and technology services customers and emphasizing community service to improve the communities it serves.
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During 2004, the Company continued to focus on improving operating efficiencies while growing internally through the effective offering and promotion of competitively priced products and services. This strategy resulted in increased earnings in 2004. Net income of $45.4 million in 2004 exceeded 2003 earnings by 11.5%, and earnings per diluted share increased $.53 to $5.68 in 2004. Net interest income, on a fully taxable-equivalent basis, increased $10.0 million in 2004 primarily due to growth in loans and investment securities and decreases in interest expense on deposits. Net income for 2004 was also positively impacted by lower provisions for loan losses, the reversal of mortgage servicing rights impairment and a gain on the sale of a banking office. Income from the origination and sale of residential real estate mortgages decreased as a result of the current sustained low interest rate environment. However, much of this revenue loss was replaced by increased fee revenue, primarily from service charges on deposit accounts, investment services fees and mortgage loan servicing fees.
The Company not only grew in terms of earnings but also in terms of asset size, surpassing $4.2 billion in total assets in 2004. Most of the increase in total assets was attributable to internal growth in loans, primarily funded by increases in customer deposits and securities sold under repurchase agreements.
Faced with continued challenges of a sustained low interest rate environment and a flattened yield curve, the Company’s focuses in 2005 are on improving internal efficiency and implementing revenue generation strategies. Improvements in internal efficiency are expected through control of operating expenses, implementation of new technologies and consolidation of like operational and administrative functions, where appropriate. Revenue generation strategies include new and expanded sales initiatives and development of new pricing opportunities.
The following discussion and analysis is intended to provide greater details of the results of operations and financial condition of the Company. The following discussion should be read in conjunction with the information under Part II, Item 6, “Selected Consolidated Financial Data” and the Company’s consolidated financial statements, including the notes thereto, and other financial data appearing elsewhere in this document.
Results of Operations
Increases in the Company’s earnings during recent years have been effected through a successful combination of internal growth and acquisitions. Internal growth experienced by the Company is reflected by an increased volume of customer loans and deposits, without giving effect to acquisitions. The Company’s internal growth has largely been accomplished through a combination of effective offering and promotion of competitively priced products and services and the opening of several de novo banking offices. Net income was $45.4 million, or $5.68 per diluted share, in 2004, as compared to $40.8 million, or $5.15 per diluted share, in 2003, and $34.5 million, or $4.41 per diluted share, in 2002.
Net Interest Income
Net interest income, the largest source of the Company’s operating income, is derived from interest, dividends and fees received on interest earning assets, less interest expense incurred on interest bearing liabilities. Interest earning assets primarily include loans and investment securities. Interest bearing liabilities include deposits and various forms of indebtedness. Net interest income is affected by the level of interest rates, changes in interest rates and changes in the composition of interest earning assets and interest bearing liabilities.
The most significant impact on the Company’s net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest earning assets and interest bearing liabilities. The volume of loans, investment securities and other interest earning assets, compared to the volume of interest bearing deposits and indebtedness, combined with the interest rate spread, produces changes in the net interest income between periods.
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The following table presents, for the periods indicated, condensed average balance sheet information for the Company, together with interest income and yields earned on average interest earning assets and interest expense and rates paid on average interest bearing liabilities.
Average Balance Sheets, Yields and Rates
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Net interest income on a fully taxable-equivalent (“FTE”) basis increased $10.0 million, or 7.0%, during 2004. This increase reflects the combined effects of increases in the average balances of interest earning assets, primarily loans and investment securities, as well as a decrease in interest expense on interest bearing liabilities resulting from declines in market interest rates. Net FTE interest income increased $4.7 million, or 3.4%, to $143.6 million in 2003, from $138.8 million in 2002, primarily due to loan and deposit growth.
The net FTE yield on interest earning assets decreased 3 basis points, or less than 1.0%, to 4.34% in 2004, as compared to 4.37% in 2003, and 29 basis points to 4.37% in 2003, as compared to 4.66% in 2002. The declining yields are primarily due to decreases in the spread between rates earned on interest earning assets and rates paid on interest bearing liabilities combined with the impact of reinvesting funds received through prepayments and repricing on loans, investment securities and borrowings at current market interest rates.
The table below sets forth, for the periods indicated, a summary of the changes in interest income and interest expense resulting from estimated changes in average asset and liability balances (volume) and estimated changes in average interest rates (rate). Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percent changes in average volume and average rate as they compare to each other.
Analysis of Interest Changes Due To Volume and Rates
Provision for Loan Losses
The provision for loan losses creates an allowance for loan losses known and inherent in the loan portfolio at each balance sheet date. The Company performs a quarterly assessment of the risks inherent in its loan portfolio, as well as a detailed review of each significant asset with identified weaknesses. Based on this analysis, the Company records a provision for loan losses in order to maintain the allowance for loan losses at assessed levels. Periodically, provisions are made for loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the provision for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. Fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses. Ultimate loan losses
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may vary from current estimates. For additional information concerning the provision for loan losses, see “Critical Accounting Estimates and Significant Accounting Policies” above.
The provision for loan losses decreased 11.4% to $8.7 million in 2004, from $9.9 million in 2003. The Company reduced its provision for loan losses due to lower levels of non-performing loans, net charge-offs and internally classified loans in 2004.
The provision for loan losses increased 7.2% to $9.9 million in 2003, from $9.2 million in 2002, primarily due to the application of historical loan loss rates to internal loan risk classifications and management’s assessment of risk associated with higher levels of criticized loans and current economic conditions in the agriculture and hotel/motel market sectors.
Noninterest Income
Principal sources of noninterest income include service charges on deposit accounts; other service charges, commissions and fees; technology services revenues; income from the origination and sale of loans; and, income from fiduciary activities, comprised principally of fees earned on trust assets. Noninterest income increased 1.6% to $71.3 million in 2004, from $70.2 million in 2003, and 15.2% to $70.2 million in 2003, from $60.9 million in 2002. Increases in noninterest income are a function of changes in each of the principal categories, as discussed below.
Services charges on deposit accounts increased 7.2% to $18.9 million in 2004, from $17.6 million in 2003, and 11.9% to $17.6 million in 2003, from $15.7 million in 2002, primarily due to increases in service fee rates for account overdraft processing and stopping check payments that became effective during the second and third quarters of 2003 and the implementation of an automated overdraft processing system during the first quarter of 2004. Additionally, declining interest rates have reduced earnings credits on business checking accounts resulting in increased check processing revenues in 2004 and 2003.
Other service charges, commissions and fees primarily include debit and credit card interchange income; mortgage servicing fees; investment services revenues; and, ATM service charge revenues. Other service charges, commissions and fees increased 20.4% to $19.2 million in 2004, from $16.0 million in 2003, and 33.5% to $16.0 million in 2003, from $12.0 million in 2002. These increases are primarily attributable to additional fee income from higher volumes of credit and debit card transactions; increases in mortgage servicing revenues due to higher volumes of mortgage loans serviced; and, increases in investment services revenues.
Technology services revenues increased 14.7% to $13.2 million in 2004, from $11.5 million in 2003. During June 2004, the Company acquired the assets of a small technology services provider. The acquisition increased revenues by approximately $742,000 during the last half of 2004. The remaining increase is primarily due to higher fee income resulting from increases in the number of customers using the Company’s item processing services and higher ATM transaction volumes. Technology services revenues increased 4.1% to $11.5 million in 2003, from $11.0 in 2002, primarily due to higher ATM transaction volumes.
Income from the origination and sale of loans includes origination and processing fees on residential real estate loans held for sale and gains on residential real estate loans sold to third parties. Fluctuations in market interest rates have a significant impact on the level of income generated from the origination and sale of loans. Higher interest rates can substantially reduce the demand for home loans and loans to refinance existing mortgages. Conversely, lower interest rates generally stimulate refinancing and home loan origination. Income from the origination and sale of loans decreased 45.4% to $8.4 million in 2004, from $15.3 million in 2003. This decline is due to a decrease in the number of new and refinanced loans resulting from an extended period of historically low interest rates. Income from the origination and sale of loans increased 66.9% to $15.3 million in 2003, from $9.2 million in 2002. Historically low market interest rates in 2003 caused a significant increase in the number of home loans originated and refinanced in 2003 as compared to 2002.
Revenues from fiduciary activities increased 11.6% to $5.7 million in 2004, from $5.1 million in 2003, and 9.1% to $5.1 million in 2003, from $4.7 million in 2002 primarily due to increases in the market value of underlying assets and increases in new accounts.
The Company recorded net losses of $797,000 on sales of investment securities during 2004, as compared to net losses on sales of $75,000 in 2003, and net gains on sales of $2.5 million in 2002. Net investment securities gains and losses were primarily used to offset impairment charges and reversals related to capitalized mortgage servicing rights that were recorded during the same periods.
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Other income primarily includes increases in bank-owned life insurance revenues, check printing income, agency stock dividends and gains on sales of assets other than investment securities. Other income increased 42.2% to $6.6 million in 2004, from $4.7 million in 2003, primarily due to a $1.7 million gain on the sale of a banking office recorded during third quarter 2004. Other income decreased 19.2% to $4.7 million in 2003, from $5.8 million in 2002 primarily due to a $1.2 million dollar gain on the sale of a banking office recorded during third quarter 2002.
Noninterest Expense
Noninterest expense increased 4.1% to $143.6 million in 2004, from $137.9 million in 2003, and 3.1% to $137.9 million in 2003, from $133.8 million in 2002. Significant components of these increases are discussed below.
Salaries, wages and employee benefits expense increased 5.7% to $74.0 million in 2004, from $70.0 million in 2003, primarily due to inflationary wage increases. Exclusive of deferred costs related to the origination of loans, salaries, wages and employee benefits expenses increased 4.3% to $81.1 million in 2004, from $77.8 million in 2003. The Company’s focus on internal efficiencies during 2004 resulted in a reduction of 43 full time equivalent employees as compared to 2003. Savings due to employee reductions were offset primarily by increased group insurance costs.
Exclusive of deferred costs related to the origination of loans, salaries, wages and employee benefits expenses increased 11.2% to $77.8 million in 2003, from $70.0 million in 2002 primarily due to inflationary wage increases and higher staffing levels to support internal growth and the acquisition of banking offices.
Occupancy expense increased 10.4% to $11.9 million in 2004, from $10.8 million in 2003, and 2.3% to $10.8 million in 2004, from $10.6 million in 2003, primarily due to higher depreciation and maintenance expenses associated with the upgrade of existing facilities and the addition of new facilities.
Furniture and equipment expense increased 14.9% to $15.1 million in 2004, from $13.1 million in 2003, due to higher depreciation associated with the upgrade of existing facilities, the addition of new facilities and technology upgrades. Furniture and equipment expense decreased less than 1.0% to $13.1 million in 2003, from $13.2 million in 2002 primarily due to decreases in maintenance expense.
Professional fees increased 16.3% to $3.2 million in 2004, from $2.7 million in 2003, primarily due to outsourcing of certain customer service functions by the Company’s technology subsidiary. The Company also incurred professional fees related to implementations of automated overdraft processing and account reconciliation systems in 2004. Professional fees increased 6.3% to $2.7 million in 2003, from $2.6 million in 2002 primarily due to fees incurred in evaluating the benefits of automating certain operational functions of the Bank.
Outsourced technology services expense increased 24.0% to $3.0 million in 2004, from $2.4 million in 2003, and 23.0% to $2.4 million in 2003, from $1.9 million in 2002, primarily due to ATM and debit card transaction processing fees paid to third party processors. These fees fluctuate with transaction volumes.
Other expenses primarily include advertising and public relations costs; office supply, postage, freight, telephone and travel expenses; other losses; and, impairment charges or reversals related to capitalized mortgage servicing rights and long-lived assets pending disposition. Other expenses decreased 7.0% to $31.4 million in 2004, from $33.8 million in 2003. During 2003, the Company expensed unamortized debt issuance costs of $1.9 million, recorded fraud losses of $561,000 and accrued $400,000 for building repairs. Also contributing to lower expense in 2004 was the reversal of impairment on mortgage servicing rights of $263,000 in 2004, as compared to impairment charges of $1.0 million in 2003. These decreases in other expenses were partially offset by increases in fees paid to directors, increases in costs associated with credit card incentive programs and inflationary increases in other expenses.
Other expenses increased 1.8% to $33.8 million in 2003, from $33.2 million in 2002, primarily due to the write-off of unamortized debt issuance costs associated with trust preferred securities redeemed in April 2003, increases in fraud losses, additional accruals for a building repair and increases in costs related to credit card incentive programs. These increases were partially offset by fluctuations in impairment charges related to capitalized mortgage servicing assets and long-lived assets pending disposition. The Company recorded impairment charges related to capitalized mortgage servicing assets of $1.0 million in 2003, as compared to $2.8 million in 2002. Additionally, during 2002, the Company recorded impairment charges of $1.3 million on equipment disposed of in 2003.
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Income Tax Expense
The Company’s effective federal tax rate was 30.6% for the year ended December 31, 2004 and 29.8% for the years ended December 31, 2003 and 2002. State income tax applies only to pretax earnings of entities operating within Montana, Colorado, Idaho and Oregon. The Company’s effective state tax rate was 3.9%, 5.6% and 6.1% for years ended December 31, 2004, 2003 and 2002, respectively. The decrease in the state tax rate for 2004 reflects the recognition of state tax benefits from prior years.
Operating Segment Results
The Company’s primary operating segment is Community Banking. The Community Banking segment represented over 90% of the combined revenues and income of the Company during 2004, 2003 and 2002, and consolidated assets of the Company as of December 31, 2004 and 2003.
The following table summarizes net income (loss) for each of the Company’s operating segments for the years indicated.
For additional information regarding the Company’s operating segments, see “Business - Operating Segments” included in Part I, Item 1, and “Notes to Consolidated Financial Statements - Segment Reporting” and “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
Summary of Quarterly Results
The following table presents the Company’s unaudited quarterly results of operations for the fiscal years ended December 31, 2004 and 2003.
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Results for the fourth quarter of 2004 improved over the fourth quarter of 2003, primarily due to increases in net interest income, which increased 7.1% as a result of internal growth. The net yield on interest earning assets for the quarter ended December 31, 2004 was 4.30%, a decrease of 4 basis points from the fourth quarter of 2003. This compression in net interest margin is the result of balance reductions on higher-yielding, fixed rate loans and increases in deposits at current market rates. The Company recorded lower provisions for loan losses during the quarter ended December 31, 2004, as compared to fourth quarter 2003 due to improvements in asset quality. Additionally, the Company recorded a reversal of impairment related to capitalized mortgage servicing rights of $367,000 during fourth quarter 2004 as compared to impairment charges of $883,000 during fourth quarter 2003. Offsetting these increases in income were higher depreciation and maintenance expenses, higher amortization expense related to mortgage servicing rights and increases in group medical insurance expense.
Results for the fourth quarter of 2004 improved over the third quarter of 2004, primarily due to increases in net interest income, lower provisions for loan losses and the reversal of impairment related to capitalized mortgage servicing rights. These increases were partially offset by decreases in income from the origination and sale of loans and higher amortization expense related to capitalized mortgage servicing rights. In addition, the Company recorded a $1.7 million gain on the sale of a banking office during third quarter 2004.
Financial Condition
Total assets increased 8.7% to $4,217 million as of December 31, 2004, from $3,880 million as of December 31, 2003, primarily due to internal growth in loans. Asset growth was primarily funded by increases in customer deposits and securities sold under repurchase agreements.
Loans
The Company’s loan portfolio consists of a mix of real estate, consumer, commercial, agricultural and other loans, including fixed and variable rate loans. Fluctuations in the loan portfolio are directly related to the economies of the communities served by the Company.
Total loans increased 7.2% to $2,740 million as of December 31, 2004, from $2,555 million as of December 31, 2003, the result of internal growth. All loan categories demonstrated growth with the exception of agricultural loans. The most significant growth occurred in loans secured by commercial real estate and construction loans, which increased 11.3% and 21.2%, respectively, from December 31, 2003. Total loans increased 14.2% to $2,555 million as of December 31, 2003, from $2,237 million as of December 31, 2002, primarily due to internal growth, particularly in loans secured by commercial real estate and construction loans, and the acquisition of a bank holding company and its bank subsidiary.
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The following table presents the composition of the Company’s loan portfolio as of the dates indicated:
Loans Outstanding
The following table presents the maturity distribution of the Company’s loan portfolio and the sensitivity of the loans to changes in interest rates as of December 31, 2004:
For additional information concerning the Company’s loan portfolio and its credit administration policies, see Part I, Item 1, “Business — Lending Activities.”
Investment Securities
The Company’s investment portfolio is managed to attempt to obtain the highest yield possible, while meeting the Company’s risk tolerance and liquidity guidelines and satisfying the pledging requirements for deposits of state and political subdivisions and securities sold under repurchase agreements. The portfolio is comprised of mortgage-backed securities, U.S. government agency securities, tax exempt securities, corporate securities and mutual funds. Federal funds sold are additional investments that are classified as cash equivalents rather than as investment securities. Investment securities classified as available-for-sale are recorded at fair value, while investment securities classified as held-to-maturity are recorded at amortized cost. Unrealized gains or losses, net of the deferred tax effect, on available-for-sale securities are reported as increases or decreases in accumulated other comprehensive income or loss, a component of stockholders’ equity.
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Investment securities increased 8.5% to $867 million as of December 31, 2004, from $800 million as of December 31, 2003, due to investment of funds primarily generated through internal deposit growth. The weighted average yield on investment securities decreased 19 basis points to 3.89% in 2004, from 4.08% in 2003, primarily due to the investment of funds received through deposit growth and early repayment of mortgage-backed investment securities in shorter duration U.S. agency securities in anticipation of market interest rate increases.
Investment securities increased less than 1% to $800 million as of December 31, 2003, from $799 million as of December 31, 2002. During 2003, available-for-sale investment securities were sold to offset mortgage servicing right impairment adjustments recorded during the same period. Proceeds from investment security sales and prepayments of mortgage-backed securities were used to fund loan growth or were reinvested in securities.
The following table sets forth the book value, percentage of total investment securities and average yield for the Company’s investment securities as of December 31, 2004:
Securities Maturities and Yield
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The maturities noted above reflect $258,150 of investment securities at their final maturities although they have call provisions within the next year. Mortgage-backed securities, and to a limited extent other securities, have uncertain cash flow characteristics that present additional interest rate risk to the Company in the form of prepayment or extension risk primarily caused by changes in market interest rates. This additional risk is generally rewarded in the form of higher yields. Maturities of mortgage-backed securities presented above are based on prepayment assumptions at December 31, 2004.
As of December 31, 2003, the Company had U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities, and mutual funds with carrying values of $241,050, $92,018, $10,684, $455,734, and $101, respectively. During 2003, weighted average yields on U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and mutual funds were 2.90%, 6.68%, 2.90%, 4.30% and 2.08%, respectively.
As of December 31, 2002, the Company had U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and mutual funds with carrying values of $241,457, $82,818, $5,770, $428,954 and $40,293, respectively. During 2002, weighted average yields on U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and mutual funds were 3.89%, 7.02%, 2.75%, 5.14% and 1.45%, respectively.
For additional information concerning investment securities, see “Notes to Consolidated Financial Statements — Investment Securities” included in Part IV, Item 15.
Premises and Equipment
Premises and equipment increased 8.4% to $122 million as of December 31, 2004, from $112 million as of December 31, 2003, primarily due to construction of new banking offices and the remodel of existing banking offices during 2004. Premises and equipment increased 21.0% to $112 million as of December 31, 2003, from $93 million as of December 31, 2002, primarily due to new main frame hardware and software placed into service during 2003, the acquisition of a bank holding company and its bank subsidiary, the construction of new banking offices and the remodel of existing banking offices.
Mortgage Servicing Rights
The Company recognizes the rights to service mortgage loans for others whether acquired or internally originated. Net mortgage servicing rights increased 22.3% to $18 million as of December 31, 2004, from $14 million as of December 31, 2003, and 71.4% to $14 million as of December 31, 2003, from $8 million as of December 31, 2002 primarily due to internal loan origination. Impairment reserves for mortgage servicing assets were $5 million as of December 31, 2004 and 2003, and $4 million as of December 31, 2002. For additional information regarding the Company’s mortgage servicing rights, see “Notes to Consolidated Financial Statements — Mortgage Servicing Rights” included in Part IV, Item 15.
Deposits
The Company emphasizes developing total client relationships with its customers in order to increase its core deposit base, which is the Company’s primary funding source. The Company’s deposits consist primarily of noninterest bearing and interest bearing demand, savings, individual retirement and time deposit accounts. Deposits increased 5.2% to $3,322 as of December 31, 2004, from $3,157 as of December 31, 2003, despite the sale of a banking office with $33 million of deposits in 2004. This increase is due to internal growth, primarily in noninterest bearing demand, interest bearing demand and savings deposits. During 2004, the Company experienced a shift in the mix of deposits from time deposits to interest bearing demand and savings deposits.
Deposits increased 8.4% to $3,157 million as of December 31, 2003, from $2,912 million as of December 31, 2002. Approximately $42 million of the increase is due to the acquisition of a bank holding company and its bank subsidiary during 2003. The remaining increase is the result of internal growth, with the most significant growth occurring in noninterest bearing deposits.
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In addition to deposits, the Company also uses other traditional funding sources to support its earning asset portfolio including other borrowed funds consisting primarily of tax deposits due to the federal government, repurchase agreements with commercial depositors and, on a seasonal basis, federal funds purchased.
For additional information concerning customer deposits, including its use of repurchase agreements, see Part I, Item 1, “Business — Funding Sources” and “Notes to Consolidated Financial Statements — Deposits” included in Part IV, Item 15.
Other Borrowed Funds
Other borrowed funds increased 12.0% to $8 million as of December 31, 2004, from $7 million as of December 31, 2003, and decreased 10.5% to $7 million as of December 31, 2003, from $8 million as of December 31, 2002. Fluctuations in other borrowed funds are generally due to timing of tax deposits made by customers and the subsequent withdrawal of funds by the federal government. For additional information on other borrowed funds as of December 31, 2004 and 2003, see “Notes to Consolidated Financial Statements — Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
Federal Funds Purchased and Securities Sold Under Repurchase Agreements
The following table sets forth certain information regarding federal funds purchased and repurchase agreements as of the dates indicated:
Long-Term Debt
The Company’s long-term debt is comprised principally of fixed rate notes with the FHLB, an unsecured revolving term loan, unsecured subordinated notes and obligations under capital leases. Long-term debt increased 30.1% to $62 million as of December 31, 2004, from $48 million as of December 31, 2003, primarily due to a $25 million advance on a five year, fixed rate borrowing from the FHLB. This advance is subject to immediate repayment at quarterly intervals beginning October 1, 2005 if the three-month London Interbank Offered Rate (“LIBOR”) equals or exceeds 5.00%. Increases in FHLB advances were offset by principal reductions on the Company’s revolving line and subordinated notes. Long-term debt increased 101.3% to $48 million as of December 31, 2003, from $24 million as of December 31, 2002 primarily due to advances on fixed rate, four and seven year borrowings from the FHLB during 2003. For additional information on long-term debt as of December 31, 2004 and 2003, see “Notes to Consolidated Financial Statements — Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
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Subordinated Debenture Held by Subsidiary Trust
The Company adopted the provisions of Financial Accounting Standards Board Revised Interpretation No. 46 (“FIN 46”) effective December 31, 2003. Upon adoption, the Company deconsolidated its investment in a variable interest subsidiary trust formed for the exclusive purpose of issuing capital trust preferred securities and using the proceeds to purchase a junior subordinated debenture issued by FIBS. The deconsolidation resulted in an increase in the Company’s debt obligation of $1 million, which represents the Company’s ownership in the subsidiary trust. For additional information on the subordinated debenture held by the subsidiary trust and the capital trust preferred securities, see “Notes to Consolidated Financial Statements - Subordinated Debenture Held by Subsidiary Trust” included in Part IV, Item 15.
Non-Performing Assets
Non-performing assets include loans past due 90 days or more and still accruing interest, nonaccrual loans, loans renegotiated in troubled debt restructurings and OREO. Management generally places loans on nonaccrual when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed from income. Approximately $1.4 million, $1.7 million, $1.7 million, $1.7 million and $1.9 million of gross interest income would have been accrued if all loans on nonaccrual had been current in accordance with their original terms for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, respectively.
Restructured loans are loans on which the Company has granted a concession on the interest rate or original repayment terms due to financial difficulties of the borrower.
OREO consists of real property acquired through foreclosure on the collateral underlying defaulted loans. The Company initially records OREO at the lower of carrying value or fair value less estimated costs to sell by a charge against the allowance for loan losses, if necessary. Estimated losses that result from the ongoing periodic valuation of these properties are charged to earnings with a provision for losses on foreclosed property in the period in which they are identified.
The following table sets forth information regarding non-performing assets as of the dates indicated:
Non-performing assets decreased 34.8% to $22 million as of December 31, 2004, from $33 million as of December 31, 2003. This decrease is primarily the result of the loans of one commercial borrower removed from nonaccrual status due to performance, the loans of one commercial borrower charged-off in 2004 and the renewal of the loans of three commercial borrowers that were past due 90 days and still accruing interest as of December 31, 2003.
Non-performing assets decreased 1.3% to $33 million as of December 31, 2003, from $34 million as of December 31, 2002 primarily due to paydowns or charge-offs of nonaccrual loans outstanding at December 31, 2002.
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In addition to the non-performing loans included in the table above, management has serious doubts as to the ability of certain borrowers to comply with the present repayment terms on performing loans, which may result in future non-performing loans. There can be no assurance that the Company has identified all of its potential non-performing loans. Furthermore, management cannot predict the extent to which economic conditions in the Company’s market areas may worsen or the full impact such conditions may have on the Company’s loan portfolio. Accordingly, there can be no assurances that other loans will not become 90 days or more past due, be placed on nonaccrual, be renegotiated or become OREO in the future.
The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of known and inherent risk in the Company’s loan portfolio. See the discussion under “Provision for Loan Losses” above. The allowance for loan losses is increased by provisions charged against earnings and reduced by net loan charge-offs. Loans are charged-off when management determines that collection has become unlikely. Consumer loans are generally charged off when they become 120 days past due. Other loans, or portions thereof, are charged off when they become 180 days past due unless they are well-secured and in the process of collection. Recoveries are recorded only when cash payments are received.
The allowance for loan losses is maintained at an amount to sufficiently provide for estimated losses based on management’s evaluation of known and inherent risks in its loan portfolio at each balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposures from outstanding loans. For commercial, agricultural and real estate loans, loss factors are applied based on the internal risk classifications of these loans. For certain consumer loans, loss factors are applied on a portfolio basis. Loss factors are based on peer and industry loss data which are comparable to the Company’s historical loss experience, and are reviewed on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio such as changes in the size and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions and detailed analyses of individual loans for which full collectibility may not be assured.
Specific allowances are established for loans where management has determined that the probability of a loss exists and will exceed the historical loss factors specifically identified based on the internal risk classification of the loans. The allocated component of the allowance for loan losses also represents the changes in the nature and volume of the loan portfolio, overall portfolio quality, industry concentrations, current economic factors and the estimated impact of current economic conditions on historical loss rates used in the model. The unallocated component of the allowance for loan losses represents estimates of losses inherent in the portfolio that are not fully captured in the allocated allowance due to model imprecision.
Management has assessed, and will continue to assess on an on-going basis, the impact of national, regional and local economic conditions on credit risk in the loan portfolio. As of December 31, 2004, delinquency trends and classified loan levels relative to prior periods indicate improvement in the loan portfolio. Management continues to closely monitor credit quality and to focus on identifying potential non-performing loans and loss exposure in a timely manner.
The following table sets forth information concerning the Company’s allowance for loan losses as of the dates and for the years indicated.
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Allowance for Loan Losses (continued)
The allowance for loan losses was $42 million, or 1.54% of period end loans, at December 31, 2004, as compared to $39 million, or 1.52% of period end loans, at December 31, 2003, and $36 million, or 1.62% of period end loans, at December 31, 2002. Net charge-offs of $5.5 million in 2004 decreased from $7.6 million in 2003, and $7.0 million in 2002.
Although management believes that it has established its allowance for loan losses in accordance with accounting principles generally accepted in the United States and that the allowance for loan losses is adequate to provide for known and inherent losses in the portfolio at each balance sheet date, future provisions will be subject to on-going evaluations of the risk in the portfolio. If the economy declines or asset quality deteriorates, material additional provisions could be required.
The allowance for loan losses is allocated to loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. Management has reviewed the allocations and believes the allowance for loan losses was adequate at all times during the five-year period ended December 31, 2004. The following table provides a summary of the allocation of the allowance for loan losses for specific loan categories as of the dates indicated. The allocations presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amount available for future losses that may occur within these categories. The unallocated portion of the allowance for loan losses and the total allowance is applicable to the entire loan portfolio.
Allocation of the Allowance for Loan Losses
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The most significant increase in allocated reserves occurred in real estate loans, which increased 8.7%, or $1.6 million, to $19.5 million in 2004, from $17.9 million in 2003, primarily due to deterioration in the credit quality of two large commercial real estate loans, continued concerns about economic conditions in the Company’s hotel/motel market sector and the application of historical loss factors to loan portfolio gradings. The allocated reserves for agricultural loans decreased $947,000, or 30.1%, to $2.2 million in 2004, from $3.1 million in 2003, primarily due to decreases in the level of internally classified loans.
The allocated reserve for real estate loans increased 64.6% to $17.9 million in 2003, from $10.9 million in 2002 primarily due to significant increases in the level of internally classified commercial real estate loans combined with enhancement of the allocation methodology discussed above in footnote 1 to the table above.
Contractual Obligations
The Company’s contractual obligations as of December 31, 2004 are summarized in the following table.
Off-Balance Sheet Arrangements
The Company has entered into various arrangements not reflected on the consolidated balance sheet that have or are reasonably likely to have a current or future effect on the Company’s financial condition, results of operations or liquidity. These include guarantees, commitments to extend credit and standby letters of credit.
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The Company guarantees the distributions and payments for redemption or liquidation of capital trust preferred securities issued by a wholly-owned subsidiary trust to the extent of funds held by the trust. Although the guarantee is not separately recorded, the obligation underlying the guarantee is fully reflected on the Company’s consolidated balance sheets as subordinated debenture held by subsidiary trust. The subordinated debenture currently qualifies as Tier 1 capital under the Federal Reserve capital adequacy guidelines. For additional information regarding the subordinated debenture, see “Notes to Consolidated Financial Statements — Subordinated Debenture Held by Subsidiary Trust” included in Part IV, Item 15.
The Company guarantees the debt of a joint venture in which it has an ownership interest. As of December 31, 2004, the joint venture had indebtedness of $6,204. For additional information regarding the joint venture, see “Notes to Consolidated Financial Statements - - Related Party Transactions” included in Part IV, Item 15.
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. For additional information regarding the Company’s off-balance sheet arrangements, see “Notes to Consolidated Financial Statements — Financial Instruments with Off-Balance Sheet Risk” included in Part IV, Item 15.
Capital Resources and Liquidity Management
Capital Resources
Stockholders’ equity is influenced primarily by earnings, dividends and, to a lesser extent, sales and redemptions of common stock and changes in the unrealized holding gains or losses, net of taxes, on available-for-sale investment securities. Stockholders’ equity increased 12.4% to $308 million as of December 31, 2004, from $274 million as of December 31, 2003, and 12.5% to $274 million as of December 31, 2003, from $244 million as of December 31, 2002, primarily due to retention of earnings. For the years ended December 31, 2004, 2003 and 2002, the Company paid aggregate cash dividends to stockholders of $12.4 million, $10.4 million and $10.1 million, respectively. During 2003, the Company recapitalized its common stock through a $25 million transfer from retained earnings.
Pursuant to FDICIA, the Federal Reserve and FDIC have adopted regulations setting forth a five-tier system for measuring the capital adequacy of the financial institutions they supervise. At December 31, 2004, the Bank had a capital level that exceeded the well-capitalized guidelines. For additional information concerning the capital levels of the Company, see “Notes to Consolidated Financial Statements — Regulatory Capital” contained in Part IV, Item 15.
Liquidity
Liquidity measures the Company’s ability to meet current and future cash flow needs as they become due. The Company manages its liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of its shareholders. The Company’s liquidity position is supported by management of its liquid assets and liabilities. Liquid assets include cash, interest bearing deposits in banks, federal funds sold, available-for-sale investment securities and maturing or prepaying balances in the Company’s held-to-maturity investment and loan portfolios. Liquid liabilities include core deposits, federal funds purchased, securities sold under repurchase agreements and borrowings. The Company does not engage in derivatives or related hedging activities to support its liquidity position.
Short-term and long-term liquidity requirements of the Company are primarily to fund on-going operations, including payment of interest on deposits and debt, extensions of credit, capital expenditures and shareholder dividends. These liquidity requirements are met primarily through cash flow from operations, redeployment of prepaying and maturing balances in the Company’s loan and investment portfolios, debt obligations and increases in customer deposits.
For additional information regarding the Company’s operating, investing and financing cash flows, see “Consolidated Financial Statements — Consolidated Statements of Cash Flows,” included in Part IV, Item 15.
As a holding company, FIBS is a corporation separate and apart from the Bank and, therefore, provides for its own liquidity. Substantially all of FIBS’ revenues are obtained from management fees and dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to FIBS. Management of FIBS believes that such restrictions will not have an impact on the ability of FIBS to meet its ongoing cash obligations. For additional information, see Part I, Item 1, “Business — Regulation and Supervision.”
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Asset Liability Management
The goal of asset liability management is the prudent control of market risk, liquidity and capital. Asset liability management is governed by policies, goals and objectives adopted and reviewed by the Bank’s board of directors. The board delegates its responsibility for development of asset liability management strategies to achieve these goals and objectives to the Asset Liability Management Committee (“ALCO”), which is comprised of members of senior management.
Interest rate risk is the risk of loss of future earnings or long-term value due to changes in interest rates. The Company’s primary source of earnings is the net interest margin, which is affected by changes in interest rates, the relationship between rates on interest bearing assets and liabilities, the impact of interest rate fluctuations on asset prepayments and the mix of interest bearing assets and liabilities.
The ability to optimize the net interest margin is largely dependent upon the achievement of an interest rate spread that can be managed during periods of fluctuating interest rates. Interest sensitivity is a measure of the extent to which net interest income will be affected by market interest rates over a period of time. Interest rate sensitivity is related to the difference between amounts of interest earning assets and interest bearing liabilities which either reprice or mature within a given period of time. The difference is known as interest rate sensitivity gap.
The following table shows interest rate sensitivity gaps and the earnings sensitivity ratio for different intervals as of December 31, 2004. The information presented in the table is based on the Company’s mix of interest earning assets and interest bearing liabilities and historical experience regarding their interest rate sensitivity.
Interest Rate Sensitivity Gaps
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Net Interest Income Sensitivity
The view presented in the preceding interest rate sensitivity gap table does not illustrate the effect on the Company’s net interest margin of changing interest rate scenarios. Management believes net interest income sensitivity provides the best perspective of how day-to-day decisions affect the Company’s interest rate risk profile. Management monitors net interest margin sensitivity by utilizing an income simulation model to subject twelve month net interest income to various rate movements. Simulations modeled quarterly include scenarios where market rates change suddenly up or down in a parallel manner and scenarios were market rates gradually change up or down at nonparallel rates resulting in a change in the slope of the yield curve. Estimates produced by the Company’s income simulation model are based on numerous assumptions including, but not limited to, the nature and timing of changes in interest rates, prepayments of loans and investment securities, volume of loans originated, level and composition of deposits, ability of borrowers to repay adjustable or variable rate loans and reinvestment opportunities for cash flows. Given these various assumptions, the actual effect of interest rate changes on the Company’s net interest margin may be materially different than estimated.
The Company targets a mix of interest earning assets and interest bearing liabilities such that no more than 5% of the net interest margin will be at risk over a one-year period should short-term interest rates shift gradually up or down 2%. As of December 31, 2004, the Company’s income simulation model predicted net interest income would decrease $5.3 million, or 3.2%, assuming a gradual 2% increase in short-term market interest rates and gradual 1.5% increase in long-term interest rates. This scenario predicts the Company’s funding sources will reprice faster than its interest earning assets and at higher rates, thereby reducing interest rate spread and net interest margin.
As of December 31, 2004, the Company’s income simulation model predicted net interest income would decrease $5.5 million, or 3.3%, assuming a gradual 2% decrease in short-term market interest rates and gradual 1.5% decrease in long-term interest rates. This scenario predicts higher prepayments of mortgage- related assets, such as mortgage loans and mortgage-backed investment securities, and that replacing these higher-rate, mortgage-related assets and investing funds generated through deposits at lower yields will reduce the Company’s net interest income. Additionally, because interest rates on deposit accounts cannot decrease to less than 0%, the income simulation model predicts that interest expense will not decrease in direct proportion to a simulated downward shift in interest rates.
The preceding interest rate sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected operating results.
Recent Accounting Pronouncements
New accounting policies adopted by the Company during 2004, and the expected impact of accounting standards recently issued but not yet adopted are discussed in “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company’s primary market risk exposure is interest rate risk. The business of the Company and the composition of its balance sheet consists of investments in interest earning assets (principally loans and investment securities) which are primarily funded by interest bearing liabilities (deposits and indebtedness). Such financial instruments have varying levels of sensitivity to changes in market interest rates. Interest rate risk results when, due to different maturity dates and repricing intervals, interest rate indices for interest earning assets decrease relative to interest bearing liabilities, thereby creating a risk of decreased net earnings and cash flow.
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The following table provides information about the Company’s market sensitive financial instruments, categorized by maturity and the instruments’ fair values at December 31, 2004. The table constitutes a “forward-looking statement.” For a description of the Company’s policies with respect to managing risks associated with changing interest rates, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition — Interest Rate Risk.”
Although the Company characterizes some of its interest-sensitive assets as securities available-for-sale, such securities are not purchased with a view to sell in the near term. Rather, such securities may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk. See “Notes to Consolidated Financial Statements — Summary of Significant Accounting Policies” included in Part IV, Item 15.
Market Sensitive Financial Instruments Maturities
The prepayment projections of net loans are based on experience and do not take into account any allowance for loan losses. The expected maturities of securities are based upon contractual maturities adjusted for projected prepayments of principal and assumes no reinvestment of proceeds. The actual maturities of these instruments could vary substantially if future prepayments differ from the Company’s historical experience. All other financial instruments are stated at contractual maturities.
Item 8. Financial Statements and Supplementary Data
The following consolidated financial statements of FIBS and subsidiaries are contained elsewhere herein [see Item 15(a)1]:
Report of McGladrey & Pullen LLP, Independent Registered Public Accounting FirmReport of Ernst & Young LLP, Independent Registered Public Accounting FirmConsolidated Balance Sheets — December 31, 2004 and 2003Consolidated Statements of Income — Years Ended December 31, 2004, 2003 and 2002Consolidated Statements of Stockholders’ Equity and Comprehensive Income — Years Ended December 31, 2004, 2003 and 2002Consolidated Statements of Cash Flows — Years Ended December 31, 2004, 2003 and 2002Notes to Consolidated Financial Statements
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There have been no disagreements with accountants on accounting and financial disclosure.
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Item 9A. Controls and Procedures
Management of the Company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of December 31, 2004, an evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, management concluded that the Company’s disclosure controls and procedures as of December 31, 2004, were effective in ensuring that information required to be disclosed in this Annual Report on Form 10-K was recorded, processed, summarized, and reported within the time period required by the SEC’s rules and forms.
There were no changes in the Company’s internal controls over financial reporting for the quarter ended December 31, 2004, that have materially affected, or are reasonably likely to materially affect, such controls.
Item 9B. Other Information
There were no items required to be disclosed in a report on Form 8-K during the fourth quarter of 2004, that were not reported.
PART III
Item 10. Directors and Executive Officers of the Registrant
Information concerning “Directors and Executive Officers of the Registrant” is set forth under the heading “Directors and Executive Officers” in the Company’s Proxy Statement and is herein incorporated by reference.
Information concerning “Compliance With Section 16(a) of the Securities and Exchange Act of 1934” is set forth under the heading “Compliance With Section 16(a) of the Securities and Exchange Act of 1934 (the “Exchange Act”)” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 11. Executive Compensation
Information concerning “Executive Compensation” is set forth under the heading “Compensation of Directors and Executive Officers” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” is set forth under the heading “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 13. Certain Relationships and Related Transactions
Information concerning “Certain Relationships and Related Transactions” is set forth under the heading “Certain Relationships and Related Transactions” in the Company’s Proxy Statement and is herein incorporated by reference. In addition, see “Notes to Consolidated Financial Statements - Related Party Transactions” included in Part IV, Item 15.
Item 14. Principal Accountant Fees and Services
Information concerning “Principal Accountant Fees and Services” is set forth under the heading “Directors and Executive Officers — Principal Accountant Fees and Services” in the Company’s Proxy Statement and is herein incorporated by reference.
PART IV
Item 15. Exhibits and Financial Statement Schedules
(a) 1. Following are the Company’s audited consolidated financial statements.
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and ShareholdersFirst Interstate BancSystem, Inc.
We have audited the accompanying consolidated balance sheet of First Interstate BancSystem, Inc. and subsidiaries (the “Company”) as of December 31, 2004, and the related consolidated statements of income, cash flows and stockholders’ equity and comprehensive income for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Interstate BancSystem, Inc. and subsidiaries at December 31, 2004, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.
/s/ MCGLADREY & PULLEN LLP
Des Moines, IowaFebruary 4, 2005
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The Board of Directors and ShareholdersFirst Interstate BancSystem, Inc.
We have audited the accompanying consolidated balance sheets of First Interstate BancSystem, Inc. as of December 31, 2003, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for the years ended December 31, 2003 and 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Interstate BancSystem, Inc. at December 31, 2003, and the consolidated results of its operations and its cash flows for the years ended December 31, 2003 and 2002, in conformity U.S. generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Salt Lake City, UtahFebruary 6, 2004
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First Interstate BancSystem, Inc. and Subsidiaries
See accompanying notes to consolidated financial statements.
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Consolidated Statements of Stockholders’ Equity and Comprehensive Income
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Consolidated Statements of Cash Flows
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Consolidated Statements of Cash Flows (continued)
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Notes to Consolidated Financial Statements
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Exhibit Index
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.