Stock Yards Bancorp - 10-Q quarterly report FY

S.Y. BANCORP, INC. AND SUBSIDIARY

Notes to Unaudited Condensed Consolidated Financial Statements

(1)            Summary of Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The consolidated financial statements of S.Y. Bancorp, Inc. (“Bancorp”) and its subsidiary reflect all adjustments (consisting only of adjustments of a normal recurring nature) which are, in the opinion of management, necessary for a fair presentation of financial condition and results of operations for the interim periods.

The financial statements include the accounts of S.Y. Bancorp, Inc. and its wholly-owned subsidiary, Stock Yards Bank & Trust Company (“Bank”). All significant intercompany transactions have been eliminated in consolidation. Bancorp also owns S.Y. Bancorp Capital Trust I (“Trust”), a Delaware statutory business trust that is a 100% owned finance subsidiary. The Trust is not consolidated in the financial statements of Bancorp. See note 4 to the financial statements below for more information on the Trust.

A description of other significant accounting policies is presented in the notes to the Consolidated Financial Statements for the year ended December 31, 2005 included in S.Y. Bancorp, Inc.’s Annual Report on Form 10-K. Certain reclassifications have been made in the prior year financial statements to conform to current year classifications.

Interim results for the three and six month periods ended June 30, 2006 are not necessarily indicative of the results for the entire year.

(a)           Critical Accounting Policies

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the board of directors. Since the application of this policy requires significant management assumptions and estimates, it could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Assumptions include many factors such as changes in borrowers’ financial condition which can change quickly or historical loss ratios related to certain loan portfolios which may or may not be indicative of future losses. To the extent that management’s assumptions prove incorrect, the results from operations could be materially affected by a higher provision for loan losses. The accounting policy related to the allowance for loan losses is applicable to the commercial banking segment of Bancorp.

Additionally, management has identified the accounting policy related to accounting for income taxes as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the board of directors. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in Bancorp’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of periodic IRS and state agency examinations, could materially impact Bancorp’s financial position and its results from operations.

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(b)           Securities

Unrealized losses on Bancorp’s bond portfolio have not been recognized in income because the bonds are of high credit quality, management has the intent and the ability to hold for the foreseeable future, and the decline in fair values is largely due to an increase in prevailing interest rates since the purchase date. The fair value is expected to recover as the securities reach their maturity date and/or interest rates decline. These investments consist of 61 and 50 separate investment positions as of June 30, 2006 and 2005, respectively that are not considered other-than-temporarily impaired.

(c)            Stock-Based Compensation

Prior to January 1, 2006, Bancorp used the intrinsic value method as described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) to measure stock-based compensation. Under the intrinsic value method, compensation expense was measured as the difference between the market value of the underlying shares and the price the employee is required to pay on the grant date, if any. Since Bancorp granted options at the current value of shares as of date of grant, no compensation expense was recorded.

On January 1, 2006, Bancorp adopted the modified version of prospective application of Statement of Financial Statement No. 123 (R) “Share-based Payment”, (“SFAS No. 123R”). Under this method, the fair value of all new and modified awards granted subsequent to the date of adoption will be recognized as compensation expense net of estimated forfeitures. Further, the fair value of any unvested awards at the date of adoption will be recognized as compensation expense, net of estimated forfeitures.

At June 30, 2006, Bancorp has one stock-based compensation plan. The 2005 Stock Incentive Plan reserved 735,000 shares of common stock for issuance of stock based awards. As of June 30, 2006, there were 543,896 shares available for future awards. Options granted have been subject to a vesting schedule of 20% per year except for those granted to certain executive officers which vest six months after grant date. All outstanding options were granted at an exercise price equal to the market value of common stock at the time of grant and expire ten years after the grant date. Bancorp’s 1995 Stock Incentive Plan expired in 2005; however, options granted under this plan expire as late as 2015.

The fair value of Bancorp’s, stock options is estimated at the date of grant using the Black-Scholes option pricing model, a leading formula for calculating the value of stock options. This model requires the input of subjective assumptions, changes to which can materially affect the fair value estimate. As a result of applying the provisions of SFAS No. 123R, Bancorp recognized, within salaries and employee benefits in the unaudited condensed consolidated income statements, stock-based compensation expense of $384,000 before income taxes and a deferred tax benefit of $134,000 resulting in a reduction of net income of $250,000, or $0.02 per basic and diluted shares for the six months ended June 30, 2006. For the second quarter of 2006, Bancorp recognized $210,000 of compensation expense before taxes, a deferred tax benefit of $74,000 and a reduction of net income of $136,000, or $0.01 per basic and diluted shares. Bancorp expects to record an additional $85,000 and $56,000 of compensation expense in the third and fourth quarters of 2006, respectively, for outstanding stock options. As a result of adoption, cash flows provided by financing activities increased by $117,000 and cash flows provided by operating activities decreased by $117,000 for the six months ended June 30, 2006.

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As of June 30, 2006 Bancorp has $783,000 of unrecognized stock-based compensation expense that will be recorded as compensation expense over 4.5 years, the weighted-average remaining life of these options. Bancorp received cash of $1,254,000 from the exercise of options during the first six months of 2006.

In accordance with the Financial Accounting Standards Board Staff Position SFAS NO. 123R— 3, “Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards”, Bancorp has elected the alternative transition method to calculate the beginning balance of the pool of excess tax benefits. The beginning balance of excess tax benefits was calculated as the sum of all net increases in additional paid-in-capital related to tax benefits from stock-based employee compensation, less the incremental stock-based after-tax compensation costs that would have been recognized if the fair value recognition provisions of SFAS No. 123 had been used to account for stock-based compensation costs.

Prior to the adoption of SFAS No. 123R, Bancorp presented all tax benefits of deductions resulting from the exercise of share-based awards as operating cash inflows in the unaudited condensed consolidated statement of cash flows. SFAS No. 123R requires the cash flows resulting from excess tax deductions related to the compensation costs recognized for the share-based awards be classified as financing cash inflows.

Had compensation cost for Bancorp’s stock-based compensation plan been determined using the fair value method as described in SFAS No. 123R, Bancorp’s net income and earnings per share for the three and six months periods ended June 30, 2005 would have approximated the pro forma amounts indicated below:

The weighted average fair value of each stock option included in the preceding pro forma amounts was estimated using a Black-Scholes option-pricing model and is amortized over the vesting period of the underlying options.

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Under SFAS 123, Bancorp recognized actual forfeitures as they occurred within the above pro forma income calculation. Under SFAS No. 123R, Bancorp is required to reduce future stock-based compensation expense by estimated forfeitures at the grant date. These forfeiture estimates are based on historical experience.

The following assumptions were used in option valuations:

The expected life of options is based on actual experience of past like-term options. All outstanding options have a 10-year contractual term. Bancorp evaluated historical exercise and post-vesting termination behavior when determining the expected life of 7.7 and 7.0 years for options granted during the first six months of 2006 and 2005, respectively.

The dividend yield and expected volatility are based on historical information corresponding to the expected life of options granted. The expected volatility is the volatility of the underlying shares for the expected term on a quarterly basis.

The risk free interest rate is the implied yield currently available on U. S. Treasury issues with a remaining term equal to the expected life of the options.

A summary of stock option activity and related information for the six months ended June 30, 2006 follows. The number of options and aggregate intrinsic value are stated in thousands of dollars.

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On January 17, 2006, Bancorp granted 196,350 options to purchase common stock shares at the current market price of $24.07. These options were awarded to employees and will primarily vest 20% per year over the next five years. Of these options, 54,600 were granted to certain executive officers and will vest six months from the date of grant. As of June 30, 2006, none of these options had vested. All options expire ten years from the date of grant.

On December 31, 2005, the Board of Directors of Bancorp accelerated the vesting of all employee stock options outstanding. This resulted in the accelerated vesting of approximately 190,000 options to purchase shares of common stock of Bancorp. The Board approved the accelerated vesting to reduce future compensation expense that Bancorp would otherwise be required to report in its consolidated financial statements upon adoption of SFAS No. 123R. By vesting these stock options early, Bancorp avoided recognizing approximately $1,000,000 in expense over future vesting periods. There are 8,000 options granted to non-employee directors that continue to vest on their original terms.

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(2)            Allowance for Loan Losses

An analysis of the changes in the allowance for loan losses for the six months ended June 30 follows (in thousands):

(3)            Federal Home Loan Bank Advances

Under a blanket collateral agreement with the Federal Home Loan Bank of Cincinnati and secured by certain residential real estate loans, the Bank has borrowed $30,000,000 via two separate fixed rate, non-callable advances of $10,000,000 and $20,000,000, which are due in February of 2007 and October of 2008, respectively, with a weighted average rate of 4.13%. Interest payments are due monthly, with principal due at maturity.

(4)            Subordinated Debentures

On June 1, 2001, S.Y. Bancorp Capital Trust I (“the Trust”), a Delaware statutory business trust and 100%-owned finance subsidiary of Bancorp, issued $20.0 million of 9.00% Cumulative Trust Preferred Securities (“Securities”). The principal asset of the Trust I is a $20.0 million subordinated debenture of Bancorp, and Bancorp owns all of the common securities of the Trust. The securities and subordinated debenture bear interest at the rate of 9.00% and mature June 30, 2031, subject to prior redemption under certain circumstances. The Securities, the assets of the Trust, and the common securities issued by the Trust are redeemable in whole or in part on or after June 30, 2006, or at any time in whole, but not in part, from the date of issuance upon the occurrence of certain events. The Securities are included in Tier 1 capital for regulatory capital adequacy determination purposes, subject to certain limitations. The obligations of Bancorp with respect to the issuance of the Securities constitute a full and unconditional guarantee by Bancorp of the Trust’s obligation with respect to the Securities.

In the second quarter of 2006, Bancorp announced its intention to call these securities on July 1, 2006. Accordingly, on July 1, 2006, Bancorp redeemed these securities at par value. Unamortized issuance costs of $879,000 will be written off, and this charge will be included in other non-interest expense in the third quarter of 2006.

The Bank also had subordinated debentures outstanding amounting to $120,000 at June 30, 2006 and $150,000 at December 31, 2005. Interest due on these debentures is at a variable rate equal to one percent less than the Bank’s prime rate adjusted annually on January 1. The rate for the debentures was 6.25% and 4.25% for 2006 and 2005, respectively. The debentures are subordinated to the claims of creditors and depositors of the Bank and are subject to redemption by the Bank at the principal amount outstanding, upon the earlier of the death of the registered owners, or an event of default by the registered owners with respect to loans from the Bank. While the debentures mature in 2049, the owners may redeem the debentures at any time.

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(5)            Intangible Assets

Statement of Financial Accounting Standards No. 142, “Goodwill and Intangible Assets” (“SFAS No. 142”), requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually. Annual evaluations have resulted in no charges for impairment. Bancorp currently has unamortized goodwill remaining from the acquisition of a bank in southern Indiana in the amount of $682,000. This goodwill is assigned to the commercial banking segment of Bancorp.

(6)            Defined Benefit Retirement Plan

The Bank sponsors an unfunded, non-qualified, defined benefit retirement plan for certain key officers. Benefits vest based on years of service. The Bank does not make contributions to this plan. Information about the components of the net periodic benefit cost of the defined benefit plan follows:

(7)            Commitments to Extend Credit

As of June 30, 2006, Bancorp had various commitments outstanding that arose in the normal course of business, such as standby letters of credit and commitments to extend credit, which are properly not reflected in the financial statements. In management’s opinion, commitments to extend credit of $349,971,000, including standby letters of credit of $15,263,000, represent normal banking transactions, and no significant losses are anticipated to result from these commitments as of June 30, 2006. Commitments to extend credit were $322,132,000, including letters of credit of $13,453,000, as of

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December 31, 2005. Bancorp’s exposure to credit loss in the event of nonperformance by the other party to these commitments is represented by the contractual amount of these instruments. Bancorp uses the same credit and collateral policies in making commitments and conditional guarantees as for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Commitments to extend credit are primarily made up of commercial lines of credit, construction and development loans and home equity credit lines. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Bancorp evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Bancorp upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and other real estate under development.

Standby letters of credit and financial guarantees written are conditional commitments issued by Bancorp to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements.

(8)            Preferred Stock

At Bancorp’s annual meeting of shareholders held in April 2003, the shareholders approved an amendment to the Articles of Incorporation to create a class of preferred stock and authorize 1,000,000 shares of this preferred stock with no par value. The relative rights, preferences and other terms of this stock or any series within the class will be determined by the Board of Directors prior to any issuance. Some of this preferred stock will be used in connection with a shareholders’ rights plan upon the occurrence of certain triggering events. None of this stock had been issued as of June 30, 2006.

(9)            Stock Dividend

On April 26, 2006 Bancorp declared a 5% stock dividend to shareholders of record on May 10, 2006 payable May 26, 2006. Share and per share information has been adjusted for this dividend.

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(10)     Net Income Per Share

The following table reflects, for the three and six month periods ended June 30, 2006 and 2005, net income (the numerator) and average shares outstanding (the denominator) for the basic and diluted net income per share computations (in thousands except per share data):

(11)     Segments

The Bank’s, and thus Bancorp’s, principal activities include commercial banking and investment management and trust. Commercial banking provides a full range of loan and deposit products to individual consumers and businesses. Commercial banking also includes the Bank’s mortgage banking and brokerage activity. Investment management and trust provides wealth management services including estate administration, retirement plan management, and custodian or trustee services.

The financial information for each business segment reflects that which is specifically identifiable or allocated based on an internal allocation method. Income taxes are allocated based on the effective federal tax rate. The provision for loan losses has been allocated to the commercial banking segment. The measurement of the performance of the business segments is based on the management structure of the Bank and is not necessarily comparable with similar information for any other financial institution. The information presented is also not necessarily indicative of the segments’ operations, if they were independent entities.

Selected financial information by business segment for the quarter and six months ended June 30, 2006 and 2005 follows:

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Principally, all of the net assets of S.Y. Bancorp, Inc. are involved in the commercial banking segment.

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S.Y.BANCORP, INC. AND SUBSIDIARY

Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

This item discusses the results of operations for S.Y. Bancorp, Inc. (“Bancorp” or “Company”), and its subsidiary, Stock Yards Bank & Trust Company (“Bank”) for the three and six month periods ended June 30, 2006 and compares that period with the same period of the previous year. Unless otherwise indicated, all references in this discussion to the Bank include Bancorp. In addition, the discussion describes the significant changes in the financial condition of Bancorp and the Bank that has occurred during the first six months of 2006 compared to December 31, 2005. This discussion should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes presented in Part 1, Item 1 of this report.

This report contains forward-looking statements under the Private Securities Litigation Reform Act that involve risks and uncertainties. Although Bancorp believes the assumptions underlying the forward-looking statements contained herein are reasonable, any of these assumptions could be inaccurate. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to the following: economic conditions both generally and more specifically in the markets in which Bancorp and its subsidiaries operate; competition for Bancorp’s customers from other providers of financial services; government legislation and regulation which change from time to time and over which Bancorp has no control; changes in interest rates; material unforeseen changes in liquidity, results of operations, or financial condition of Bancorp’s customers; other risks detailed in Bancorp’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of Bancorp.

Overview of 2006 through June 30

The second quarter of 2006 was highlighted by higher earnings as a result of an improved net interest margin, ongoing growth in the loan portfolio, and an increase in non-interest income, particularly fee income for investment management and trust services. With these factors, Bancorp completed the second quarter of the year with net income exceeding the comparable period of 2005 by 7%. For the first half of the year, net income exceeded the comparable period of 2005 by 9%.

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 impacts profitability. Business volumes are influenced by overall economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.

Net interest income was up 11% for the second quarter and 13% year to date compared to the same periods of 2005, due to improved net interest margin and loan growth. Net interest margin for the second quarter of 2006 improved 17 basis points compared to the same quarter last year and 15 basis points compared to the first quarter of 2006. The Bank has been able to hold down deposit costs as market interest rates have increased. With approximately half of the loan portfolio comprised of variable rate loans, increases in rates earned on loans have outpaced increases in rates paid on deposits. Funding costs have increased in 2006 primarily as the result of certificate of deposit promotions in 2006 to support anticipated loan growth.

With fee income from investment management and trust services at the forefront, Bancorp has a higher than industry average proportion of non-interest revenues which also has fueled net income growth. Compared to the same periods of last year, total non-interest income grew 5% for both the second quarter and first six months. Growth in non-interest income partially offset growth in non-interest expenses, which were up 2% in the second quarter and 6% in the first half of 2006 compared to 2005. Salaries and employee benefits are the largest

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component of non-interest expenses and these expenses increased due to new share-based compensation expense, annual compensation increases, and rising benefit costs. The Company’s efficiency ratio improved to 53.9% from 58.3% in the first quarter of 2006 and 57.4% in the second quarter last year. Management expects the efficiency ratio to return to more historical levels in the second half of the year as it fills vacancies in several staff positions.

Operating results in 2006 were affected by a higher provision for loan losses. Net charge-offs for both the first and second quarters of 2006 were 3 basis points of average loans. Non-performing loans at June 30, 2006 increased to $7,255,000 compared to $5,331,000 at the end of the first quarter of 2006. Bancorp’s process of evaluating the credit risk inherent in the loan portfolio considers data including non-performing loans, past due loans, charge offs, internal watch lists, the nature of the Bank’s loan portfolio and relevant economic data. Taking into consideration all relevant data, management provided $600,000 in the second quarter and $350,000 in the first quarter of 2006. Management considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at June 30, 2006.

The Company announced two capital transactions during the second quarter. In April, the Company’s Board of Directors declared a 5% stock dividend on its common stock to shareholders of record as of May 10, which was distributed to shareholders on May 26, 2006. All share and per share information has been adjusted for the 5% stock dividend. In May, the Company announced that on July 1, 2006, it would redeem all of its $20 million issuance of 9.00% cumulative trust preferred securities. In connection with the redemption, the Company will write off unamortized issuance costs in the third quarter totaling $879,000.

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

a)             Results Of Operations

Net income of $5,868,000 for the three months ended June 30, 2006 increased $376,000, or 7%, from $5,492,000 for the comparable 2005 period. Basic net income per share was $0.41 for the second quarter of 2006, an increase of 8% from the $0.38 for the same period in 2005. Net income per share on a diluted basis was $0.40 for the second quarter of 2006 compared to $0.37 for the second quarter of 2005; an 8% increase. Annualized return on average assets and annualized return on average stockholders’ equity were 1.76% and 18.02%, respectively, for the second quarter of 2006, compared to 1.74% and 18.45%, respectively, for the same period in 2005.

Net income of $11,188,000 for the six months ended June 30, 2006 increased $919,000, or 9%, from $10,269,000 from the comparable 2005 period. Basic net income per share was $0.77 for the first six months of 2006, an increase of 10% from the $0.70 for the same period in 2005. Net income per share on a diluted basis was $0.76 for the first six months of 2006 compared to $0.69 for the first six months of 2005. This represents a 10% increase. Annualized return on average assets and annualized return on average stockholders’ equity were 1.68% and 17.42%, respectively, for the first six months of 2006, compared to 1.66% and 17.44%, respectively, for the same period in 2005.

Net Interest Income

The following tables present the average balance sheets for the three and six month periods ended June 30, 2006 and 2005 along with the related calculation of tax-equivalent net interest income, net interest margin and net interest spread for the related periods. See the notes following the tables for further explanation.

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