Stock Yards Bancorp - 10-K annual report

S.Y. BANCORP, INC.

Form 10-K

Index

Executive Officers of the Registrant

The following table lists the names and ages (as of December 31, 2004) of all current executive officers of Bancorp. Each executive officer is appointed by Bancorp’s Board of Directors to serve at the pleasure of the Board. There is no arrangement or understanding between any executive officer of Bancorp and any other person(s) pursuant to which he/she was or is to be selected as an officer.

Mr. Brooks was appointed Chairman and Chief Executive Officer of Bancorp and the Bank in 1993. Prior thereto, he was President of Bancorp and the Bank.  Mr. Brooks retired as Chairman and Chief Executive Officer of Bancorp effective January 1, 2005.  Mr. Brooks remains a member of the board of directors.

Mr. Heintzman was appointed President of Bancorp and the Bank in 1993. Prior thereto, he served as Treasurer and Chief Financial Officer of Bancorp and Executive Vice President of the Bank.  Mr. Heintzman has been named to the additional posts of Chairman and Chief Executive Officer by the board of directors effective January 1, 2005.

Ms. Thompson was appointed Executive Vice President of Bancorp and the Bank in 1996. Ms. Thompson has been named Senior Executive Vice President as of January 18, 2005.  She joined the Bank in 1992 as Senior Vice President and is Manager of the Investment Management and Trust Department along with the sales, service and marketing area of the Bank.

Mr. Smith was appointed Executive Vice President of the Bank in 1996. Prior thereto, he was Senior Vice President of the Bank. He is the Chief Credit Officer of the Bank, responsible for Bank-wide lending policy and operations.

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Bancorp’s financial statements or tax returns.  Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact Bancorp’s financial position and its results from operations.  Additional information regarding income taxes is the “Income Taxes” section below and note 7 to the financial statements.

Overview of 2004

The following discussion should be read in conjunction with Bancorp’s consolidated financial statements and accompanying notes and other schedules presented elsewhere in this report.

As is the case with most banks, the primary source of Bancorp’s revenue is net interest income and fees from various financial services provided to customers.  Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities.  Loan volume and the interest rates earned on those loans are critical to overall profitability. Similarly deposit volume is crucial to funding loans, and the rates on those deposits directly impact profitability. Business volumes are influenced by overall economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.

During 2004, the business environment was dynamic and challenging in many respects, characterized by an industry-wide slowdown in mortgage refinancings, a historically low overall interest rate environment during much of the year and improving economic trends during the latter part of the year.  Overall, the positive outweighed the negative as Bancorp completed its seventeenth consecutive year of higher earnings.

The Bank reorganized the structure of its lending departments during 2004 to improve efficiencies, emphasize credit quality and help revitalize loan growth.  Economic activity was stronger during the fourth quarter of 2004 and combined with the Bank’s reorganization efforts, the Bank was able to capitalize on this, resulting in loan growth during the quarter which exceeded any quarterly level seen in the past three years.

The low interest rate environment had an unfavorable effect on Bancorp’s net interest income as the net interest margin was negatively affected for the year.  Low rates in the first two quarters of the year resulted in lower margins as rates on earning assets fell and rates on many interest bearing liabilities approached zero.  As interest rates began to rise in the second half of the year, net interest margin showed improvement between the third and fourth quarters, but was still less than all of 2003.

Bancorp’s diverse revenue stream proved key to earnings growth.  The large decline in mortgage banking income was offset somewhat by the growth in investment management and trust fees as well as other categories of fee income including brokerage and bankcard transaction revenue.

Results in 2004 were also positively affected by a lower provision for loan losses.  Net charge-offs reached their lowest level since 2000.  Bancorp’s process of evaluating the inherent risk in the portfolio considered this data and other information in the evaluation of the risk in the loan portfolio to determine the required balance in the allowance for loan losses account and the corresponding provision for loan losses.

The following sections will provide more details on subjects presented in this overview.

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Results of Operations

Net income was $18,912,000 or $1.33 per share on a diluted basis in 2004.  This compares to $17,709,000 or $1.27 per share in 2003 and $15,650,000 or $1.12 per share in 2002.  The increase in 2004 net income was attributable to moderate growth in net interest income, flat non-interest income and a reduction in the provision for loan losses that was partially offset by increased non-interest expenses. Earnings include a 3.7% increase in fully taxable equivalent net interest income and a 0.7% increase in non-interest income.  Non-interest income was helped by income from investment management and trust which increased 13.6% as assets under management increased 10.4% during the year.  This income and other fees related income helped offset a significant 58.3% decrease in mortgage banking income.  The mortgage department was hampered during the year by an industry-wide slowdown in mortgage refinancings.  Non-interest expenses increased only 1.2% as salaries and benefits rose very slightly and other categories of expense grew at restrained levels.  The provision for loan losses was down 18.0% for the year as net charge-offs for the year were down 44% from the prior year.

The following paragraphs provide a more detailed analysis of the significant factors affecting operating results.

Net Interest Income

Net interest income, the most significant component of Bancorp’s earnings, is total interest income less total interest expense.  Net interest spread is the difference between the taxable equivalent rate earned on average interest earning assets and the rate expensed on average interest bearing liabilities.  Net interest margin represents net interest income on a taxable equivalent basis as a percentage of average earning assets.  Net interest margin is affected by both the interest rate spread and the level of non-interest bearing sources of funds, primarily consisting of demand deposits and stockholders’ equity.  The level of net interest income is determined by the mix and volume of interest earning assets, interest bearing deposits and interest bearing liabilities and by changes in interest rates. The discussion that follows is based on tax equivalent interest data.

Bancorp’s net interest margin and net interest spread were negatively affected during the year by decreases in average rates earned on loans and investment securities as higher yielding assets matured, while average rates on interest bearing liabilities decreased to a lesser extent.  Management believes that an interest rate increase in 2005 could have a positive impact on both spread and margin, while a decrease in interest rates could have a negative impact on net interest spread and margin.  Bancorp expects assets to reprice more quickly than liabilities with a change in interest rates.  However, margin contraction could occur under a flat or rising rate scenario due to the effect of competitive pressures on deposit rates.

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Comparative information regarding net interest income follows:

bp = basis point = 1/100th of a percent

Prime rate is included above to provide a general indication of the interest rate environment in which the Bank operated.  A large portion of the Bank’s variable rate loans were indexed to the Bank’s prime rate and reprice as the prime rate changes, unless they reach a contractual floor or ceiling.  Many fixed rate loans were indexed to the five year Treasury bond.  The flattening of the Treasury yield curve resulted in some narrowing interest spreads despite the Bank’s asset sensitive position in 2004.

Asset/Liability Management and Interest Rate Risk

Managing interest rate risk is fundamental for the financial services industry. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity while attempting to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.

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Interest Rate Simulation Sensitivity Analysis

Bancorp uses an earnings simulation model to estimate and evaluate the impact of changing interest rates on earnings. The simulation model is designed to reflect the dynamics of interest earning assets, interest bearing liabilities and off-balance sheet financial instruments in a one year forecast. By estimating the effects of interest rate increases and decreases, the model can reveal approximate interest rate risk exposure. The simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time.  The model is therefore a tool to indicate earnings trends in given interest rate scenarios and does not indicate actual expected results.  The December 31, 2004 simulation analysis indicates that an increase in interest rates would have a positive effect on net interest income, and a decrease in interest rates would have a negative effect on net interest income.  These estimates are summarized below.

To assist in achieving a desired level of interest rate sensitivity, management has in the past entered into derivative financial instruments that are designed to mitigate the effect of changes in interest rates. Derivative financial instruments can be a cost and capital efficient method of modifying interest rate risk sensitivity. Based upon management’s assessment of interest rate sensitivity, Bancorp had no derivative financial instruments at December 31, 2004.

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The following table presents the increases in net interest income due to changes in rate and volume computed on a tax equivalent basis and indicates how net interest income in 2004 and 2003 was impacted by volume increases and the lower average interest rate environment. The tax equivalent adjustments are based on a 35% federal tax rate. The change in interest due to both rate and volume has been allocated to the change due to rate and the change due to volume in proportion to the relationship of the absolute dollar amounts of the change in each.

Taxable Equivalent Rate/Volume Analysis

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Provision for Loan Losses

In determining the provision for loan losses charged to expense, management considers many factors. Among these are the quality of the loan portfolio, previous loss experience, the size and composition of the loan portfolio, changes in lending personnel and an assessment of the impact of current economic conditions on borrowers’ ability to pay. The provision for loan losses is summarized below:

The provision for loan losses decreased during the year in response to the Company’s assessment of inherent risk in the loan portfolio.  Net charge-offs during the year reached their lowest annual total since 2000, pointing to solid loan quality during 2004.  See “Financial Condition-Nonperforming Loans and Assets” for further discussion of non-performing loans.  See “Financial Condition-Summary of Loan Loss Experience” for further discussion of loans charged off during the year.

The Bank’s loan portfolio is diversified with no significant concentrations of credit. Geographically, most loans are extended to borrowers in the Louisville, Kentucky metropolitan area. The adequacy of the allowance is monitored on an ongoing basis and it is the opinion of management that the balance of the allowance for loan losses at December 31, 2004 is adequate to absorb losses inherent in the loan portfolio as of the financial statement date. See “Financial Condition-Allowance for Loan Losses” for more information on the allowance for loan losses.

Non-Interest Income and Non-Interest Expenses

The following tables provide a comparison of the components of non-interest income and expenses for 2004, 2003 and 2002. The tables show the dollar and percentage change from 2003 to 2004 and from 2002 to 2003. Below each table is a discussion of significant changes and trends.

One of the largest components of non-interest income is the income from investment management and trust services.  This area of the Bank continues to grow through attraction of new business and customer retention. At December 31, 2004 assets under management totaled $1.343 billion compared to $1.216 billion at December 31, 2003 and $1.010 billion as of December 31, 2002.  Because assets under management are

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expressed in terms of fair value, increases in market value of existing accounts during the last two years and the attraction of new business have both served to increase assets under management.  Growth in the department’s assets consisted primarily of personal trust accounts during both 2004 and 2003.

Growth in service charges on deposit accounts is primarily due to increased account volumes for both 2004 and 2003.  Promotion of retail accounts has presented opportunities for growth in deposit accounts and increased fee income.  Additionally, the rates on service charges on deposit accounts were increased late in the first quarter of 2003.

Bankcard transaction revenue primarily represents income that the Bank derives from customers’ use of debit cards.  As the popularity of these cards has grown during 2003 and 2004, there have been increases in the number of transactions by existing cardholders as customers recognize the convenience that the cards offer.  The growth rate of this account was slowed during 2003 by a class action lawsuit brought by several retail merchants against VISA®USA and MasterCard® challenging rules imposed by VISA and MasterCard governing the acceptance of debit and credit cards by merchants.  The lawsuit resulted in a reduction of interchange rates effective August 1, 2003 and established that rates on and after January 2004 would be established from time to time reflecting competitive considerations.  Although the fees per transaction have been reduced, the Bank expects fees to continue to grow as volume growth should offset any rate reduction.

The Bank operates a mortgage banking company within its retail banking division of the Bank. This division originates residential mortgage loans and sells the loans in the secondary market. The division offers conventional, VA and FHA financing, as well as a program for low-income first time home buyers. Loans are made for both the purchase of and refinancing of homes. Virtually all loans originated by the mortgage banking company are sold in the secondary market with servicing rights released.  Interest rates on the loans sold are locked with the buyer and investor, thus Bancorp bears no interest rate risk related to these loans.  Interest rates on conventional mortgage loans directly impact the volume of business transacted by the mortgage banking division. Record low mortgage rates in 2002 and the first three quarters of 2003 led to record volume both years, while higher rates in late 2003 and 2004 led to an industry-wide slowdown in loan volume during 2004.

Brokerage fees increased during 2004 as the sales efforts of our brokers helped to spur investor activity and resulted in higher brokerage commission levels.  The Company continues to be excited about offering a fuller compliment of financial services to its customer base and feels that brokerage services are a key component of that strategy.

Other non-interest income declined during 2004 for several reasons and primarily reflects the slowdown in mortgage banking activity.  These declines more than offset increased income due to the purchase of two bank-owned life insurance policies during the second half of 2004 to help offset increasing employee benefit costs.  A total premium of $20 million, invested in the third quarter of 2004, generated income of $342,000 during 2004.  Contributing factors to the increase for 2003 included the continued growth of income related to internet banking and other categories related to mortgage refinancing fees and income such as title insurance.  There were also a few one time items during 2003, the most significant being income of $256,000 related to the demutualization of an insurance company which held policies related to a defined benefit retirement plan for certain key officers.  See Note 13 to Bancorp’s consolidated financial statements for further discussion of the defined benefit retirement plan.

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Salaries and benefits are the largest component of non-interest expenses.  Increases in personnel expense rose in part from regular salary increases during 2004 and 2003, but these increases were more than offset in 2004 by two factors.  The first was a decrease in expenses related to the Company’s self-funded health insurance plan, which experienced better than expected claims experience in 2004.  The second factor in 2004 was lower levels of annual bonus pay, much of which was tied to the Company’s annual minimum target of 10% for earnings growth.  The increase in 2003 can be further attributed to increases in health insurance costs and higher levels of incentive pay as compared to 2002.  The Bank continues to add employees to support growth. At December 31, 2004, the Bank had 416 full-time equivalent employees compared to 385 at the same date in 2003 and 379 for 2002.  There are no significant obligations for post-retirement or post-employment benefits.

Net occupancy expense has increased as the Bank has added banking centers.  During 2004, the Bank opened two locations.  It opened four locations in 2003.  In addition, in June the Bank’s Indianapolis, Indiana location was converted from a loan production office into a full service branch and was moved to a new location.  In 2003, the Investment Management and Trust department relocated to new office space.  At December 31, 2004 the Bank had twenty-four banking center locations including the main office.

Data processing expenses rose as the Bank continues to update computer equipment and software as technology advances. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense.  Furniture and fixtures expense has also increased with the addition of banking centers.  State bank taxes, which are primarily based on average capital and deposit levels, were flat for the year as the Bank accrued for a potential tax increase in late 2003 related to the holding company which never materialized.  The change in the state franchise tax was reversed by the State Assembly in 2004 and the overaccrual was used to decrease the 2004 expense.

Other non-interest expenses have decreased in 2004 as declines in expenses related to a decline in mortgage banking activity offset increases in various expenses related to the Bank’s growth including advertising and marketing.  In 2003, non-interest expenses increased due to numerous factors and reflected the Bank’s overall growth.  Among the most significant costs that increased in 2003 were expenses related to the increase in mortgage banking activity during the year.

Income Taxes

A three year comparison of income tax expense and effective tax rate follows:

Bancorp’s overall tax rate has fallen due to increased investment in low income housing tax credits.

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Financial Condition

Earning Assets and Interest Bearing Liabilities

Summary information with regard to Bancorp’s financial condition follows:

The Bank has experienced steady growth in earning assets over the last several years. Growth of average earning assets occurred primarily in the area of loans and taxable securities.  From year end 2003 to year end 2004, average loans increased approximately 7.1% and average taxable securities increased 17.0%.  More specifically, period end commercial and industrial loans increased 13.9%, while construction loans increased 53.7%.  Also affecting overall loan growth was a 4.8% growth rate in consumer loans and a 7.4% increase in real estate loans, Bancorp’s largest loan category.  The growth of the securities portfolio can be attributed to overall growth in balance sheet and the need of certain deposit accounts to be collateralized by securities.  The growth in average earning assets during 2003 was primarily due to average loans which increased 7.6% and average taxable securities which grew 10.1%.

The increase in average interest bearing liabilities from 2003 to 2004 occurred primarily in interest bearing demand deposits, money market deposits, and savings accounts.  In addition, the Bank utilized fixed rate advances from the Federal Home Loan Bank during 2004 as a more favorably priced alternative to time deposits.  The Bank had $30 million in outstanding advances as of December 31, 2004 and none in 2003.  The growth in the various types of interest bearing checking accounts in 2004 can be attributed to the Bank’s continued expansion in its primary market.  On the other hand, average time deposits shrunk by 9.0% during 2004 as Bancorp utilized less expensive sources of funds.  Based on slower than expected loan growth during the year and the availability of cheaper funding sources, Bancorp intentionally let some of the time deposit portfolio run off during 2004.  The overall increase in average interest bearing liabilities in 2003 can also be attributed to interest bearing transaction deposits.

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Average Balances and Interest Rates – Taxable Equivalent Basis

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Securities

The primary purpose of the securities portfolio is to provide another source of interest income, as well as liquidity management. In managing the composition of the balance sheet, Bancorp seeks a balance between earnings sources and credit and liquidity considerations.

Securities intended to be held until maturity are carried at amortized cost. Securities available for sale include securities that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and prepayment risk changes. Securities available for sale are carried at fair value with unrealized gains or losses, net of tax effect, included in stockholders’ equity.

The carrying value of securities is summarized as follows:

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The maturity distribution and weighted average interest rates of debt securities at December 31, 2004, are as follows: