Stock Yards Bancorp - 10-Q quarterly report FY

S.Y. BANCORP, INC. AND SUBSIDIARY

Condensed Consolidated Balance Sheets

June 30, 2007 and December 31, 2006

(In thousands, except share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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S.Y.  BANCORP, INC. AND SUBSIDIARY

Unaudited Condensed Consolidated Statements of Income

For the three and six months ended June 30, 2007 and 2006

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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S.Y. BANCORP, INC. AND SUBSIDIARY

Unaudited Condensed Consolidated Statements of Cash Flows

For the six months ended June 30, 2007 and 2006

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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S.Y. BANCORP, INC. AND SUBSIDIARY

Unaudited Condensed Consolidated Statement of Changes in Stockholders’ Equity

For the six months ended June 30, 2007

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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S.Y. BANCORP, INC. AND SUBSIDIARY

Unaudited Condensed Consolidated Statements of Comprehensive Income

For the three and six months ended June 30, 2007 and 2006

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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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 consolidated financial statements include the accounts of S.Y. Bancorp, Inc. and its wholly-owned subsidiary, Stock Yards Bank & Trust Company (“Bank”).  Significant intercompany transactions and accounts have been eliminated in consolidation.

A description of other significant accounting policies is presented in the notes to the Consolidated Financial Statements for the year ended December 31, 2006 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, 2007 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 or lower 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.

(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

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purchase date.  The fair value is expected to recover as the securities reach their maturity date and/or interest rates decline.  Bonds with unrecognized unrealized losses consist of 78 and 69 separate investment positions as of June 30, 2007 and December 31, 2006, respectively that are not considered other-than-temporarily impaired.

(c)                                  Stock-Based Compensation

On January 1, 2006, Bancorp adopted the modified version of prospective application of Statement of Financial Standard 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 was recognized as compensation expense, net of estimated forfeitures.

Bancorp’s 1995 Stock Incentive Plan expired in 2005; however, options granted under this plan expire as late as 2015. The 2005 Stock Incentive Plan reserved 735,000 shares of common stock for issuance of stock based awards.  As of June 30, 2007, there were 401,664 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.  Restricted shares granted to executive officers are subject to a vesting schedule of one-third per year.  Certain other officers received grants vesting over two to five years.

The fair value of Bancorp’s stock options is estimated at the date of grant using the Black-Scholes option pricing model, an accepted and widely used 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 for the six months ended June 30, 2007 and 2006, within salaries and employee benefits in the unaudited condensed consolidated income statements, stock-based compensation expense of $242,000 and $384,000 before income taxes and a deferred tax benefit of $85,000 and $134,000 resulting in a reduction of net income of $157,000 and $250,000, or $0.01 and $0.02, in both years, per basic and diluted shares, respectively.  For the second quarter of 2007 and 2006, Bancorp recognized $189,000 and $210,000 of compensation expense before taxes, a deferred tax benefit of $66,000 and $74,000 and a reduction of net income of $123,000 and $136,000, or $0.01 and $0.01, in both years, per basic and diluted shares, respectively.  Bancorp expects to record an additional $224,000 of compensation expense in 2007.  As of June 30, 2007 Bancorp has $1,317,000 of unrecognized stock-based compensation expense.  Related to stock options is $1,251,000, which will be recorded as compensation expense over the next 4.5 years, the weighted-average remaining life of these options.  Related to restricted shares is $66,000, which will be recorded as stock compensation expense over the next 2.5 years, the weighted average remaining life of these restricted shares.

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

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recognized if the fair value recognition provisions of SFAS No. 123 had been used to account for stock-based compensation costs.

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.  Cash flows provided by financing activities relating to excess tax benefits from share-based compensation arrangements increased by $17,000 and $117,000 and cash flows used in operating activities decreased by $17,000 and $117,000 for the six months ended June 30, 2007 and 2006, respectively. Bancorp received cash of $541,000 and $1,254,000 from the exercise of options during the first six months of 2007 and 2006, respectively.

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 years for options granted during the first six months of 2007 and 2006.

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, 2007 follows.  The number of options and aggregate intrinsic value are stated in thousands of dollars.

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On February 20, 2007, Bancorp granted 151,550 options to purchase common stock shares at the current market price of $26.83 and a fair value of $6.14.  These options were awarded to employees and will primarily vest 20% per year over the next five years.  Of these options, 36,500 were granted to certain executive officers and will vest six months from the date of grant.  On May 15, 2007, Bancorp granted a new director 1,000 options to purchase common stock shares at the current market price of $24.02 and a fair value of $6.14.  All options expire ten years from the date of grant.

Also, on February 20, 2007, Bancorp adopted a restricted stock program under the terms of the Company’s 2005 Incentive Stock Plan.  Bancorp granted 2,775 shares of common stock at the current market price of $26.83.  Shares were granted to executive officers and will vest one-third per year over the next three years.  Certain other officers received grants vesting over two to five years.  As of June 30, 2007, none of these restricted shares had vested or canceled.

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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 outstanding borrowings of $70,000,000, at June 30, 2007, via three separate advances. The first two are fixed rate, non-callable advances of $20,000,000 and $30,000,000, which are due in October of 2008 and November of 2009, respectively.  The third advance of $20,000,000 is a fixed rate advance eligible to be called by the FHLB after 12 months, in May of 2008, and then quarterly going forward until its maximum maturity in May of 2012.  At June 30, 2007, the weighted average rate of these advances was 4.84%.  Interest payments are due monthly, with principal due at maturity.

(4)           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 goodwill 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.

(5)           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:

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(6)           Commitments to Extend Credit

As of June 30, 2007, Bancorp had various commitments outstanding that arose in the normal course of business, including 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 $429,988,000, and standby letters of credit of $16,302,000, represent normal banking transactions, and no significant losses are anticipated to result from these commitments as of June 30, 2007. Commitments to extend credit were $359,070,000, and letters of credit were $17,044,000, as of December 31, 2006. 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.

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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.

(7)           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, 2007.

(8)           Net Income Per Share

The following table reflects, for the three and six month periods ended June 30, 2007 and 2006, 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):

(9)           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 investment management, trust and estate administration, and retirement plan services.

The financial information for each business segment reflects that which is specifically identifiable or allocated based on an internal allocation method.  Principally, all of the net assets of Bancorp are involved in the commercial banking segment.  Income taxes are allocated based on the effective federal tax rate.  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

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information presented is also not necessarily indicative of the segments’ operations, if they were independent entities.

Selected financial information by business segment for the three and six months ended June 30, 2007 and 2006 follows:

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(10)         Income Taxes

Effective January 1, 2007, Bancorp adopted Financial Accounting Standards Board Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 provides guidance on financial statement recognition and measurement of tax positions taken, or expected to be taken, in tax returns.  The initial adoption of FIN 48 had no impact on the Company’s financial statements.  As of January 1, 2007, the gross amount of unrecognized tax benefits was $311,000.  If recognized, all of the tax benefits would increase net income, resulting in a decrease of the effective tax rate.  Management does not anticipate significant adjustments to the total amount of unrecognized tax benefits within the next twelve months.

The amount of unrecognized tax benefits may increase or decrease in the future for various reasons including adding amounts for current tax year positions, expiration of open income tax returns due to statutes of limitation, changes in management’s judgment about the level of uncertainty, status of examination, litigation and legislative activity and the addition or elimination of uncertain tax positions.

Bancorp’s policy is to report interest and penalties, if any, related to unrecognized tax benefits in income tax expense.  As of the date of adoption of FIN 48, the amount accrued for the potential payment of interest and penalties was $31,000.  Federal and state income tax returns are open and subject to examination from the 2003 tax return year and forward.

There have been no material changes in unrecognized tax benefits from tax positions taken since the date of adoption.

(11)         Subsequent Event

On July 17, 2007, the Board of Directors approved the expansion of the Company’s stock repurchase plan by 550,000 shares.  The Board also set July 2008 as the plan’s expiration date.

The Board of Directors first implemented the repurchase plan in 1999 and expanded the number of shares approved in 2005.  At that time, the Company’s plan authorized the repurchase of up to 577,500 shares, as adjusted for a five percent stock dividend in 2006.  As of June 30, 2007, there were approximately 17,500 shares remaining for repurchase.  With these remaining shares and the 550,000 shares approved in July 2007, the Company has the ability to repurchase approximately 567,500 shares.

Under its stock repurchase program, Bancorp may purchase shares from time to time at prevailing prices in open market transactions, subject to market conditions, share price and other considerations.  Unsolicited negotiated transactions also are permitted.

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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, 2007 and compares those periods with the same periods 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 2007 compared to December 31, 2006. 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 2007 through June 30

The second quarter of 2007 was highlighted by higher earnings driven primarily by a strong earning asset base and continued growth in the Company’s investment management and trust services.  Strong credit quality performance also characterized S.Y. Bancorp’s results for the second quarter, leading to a reduction in Company’s provision for loan losses as compared to the second quarter of 2006 and first quarter of 2007 and helping to offset increasing competitive pressures affecting loan growth and margin.  With these factors, the Company completed the second quarter and the first half of the year with net income exceeding the comparable period of 2006 by 7%.

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 rates paid on 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.

Net interest income increased 1% for the second quarter and 2% year to date compared with the year-earlier periods.  The increase for the second quarter reflected growth in net interest earning assets, offset by ongoing pressure on the net interest margin.  Growth in earning assets has been affected by payoffs in the construction loan portfolio and other transaction based business and slowly replaced by growth in commercial and industrial loans.  Although net interest margin improved three basis points in the second quarter compared with the first quarter of 2007, net interest margin for the second quarter, at 4.26%, declined 15 basis points versus 4.41% in the year-earlier quarter.  This compression was attributed to several factors.  The Company has had higher interest expense associated with recent promotions of certificates of deposit causing the increase in deposit yields to outpace the increase in loan yields.  Also, the persistence of a relatively flat yield curve, together with mounting competitive pressures on both loan and deposit interest rates, continue to adversely affect net interest margin. 

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While the Company believes it remains well positioned for the current interest rate environment, with its loan portfolio being split between approximately 60% fixed and 40% variable rates, it expects ongoing pressure on net interest margin.

Operating results were favorably impacted by a lower provision for loan losses in the second quarter of 2007.  Based on the Bank’s systematic credit risk assessment process, including a declining level of non-performing loans, the Company recorded a provision for loan losses of $460,000 in the second quarter compared to $600,000 in the second quarter of 2006.  For the first six months of 2007, the loan loss provision totaled $1,240,000 versus $950,000 in the year-earlier period.  The Company’s allowance for loan losses was 1.04% of total end-of-quarter loans at June 30, 2007, compared with 1.06% of total end-of-quarter loans at March 31, 2007, and 1.14% at June 30, 2006.

Non-performing loans at June 30, 2007 were 0.41%, relative to total loans, which showed improvement from 0.45% at the end of the first quarter of 2007, as well as from the 0.67% in the same quarter last year.  Net charge-offs also remained low at 0.05% of average loans compared with 0.07% in the first quarter of 2007 and 0.03% in the second quarter of 2006.  Management continues to view these metrics as an indication of overall sound asset quality and believes it has appropriately recognized the loan-loss exposure in its portfolio.

Non-interest income increased 7% in the second quarter compared with the same quarter last year, primarily due to higher investment management and trust income, which rose 14% during the quarter.  This, along with higher bankcard transaction revenue, gains on sales of mortgage loans and other non-interest income, offset lower service charges on deposit accounts and brokerage fees and commissions for the quarter.  Non-interest income increased 5% in the first half of 2007 compared with the year-earlier period, again driven primarily by investment management and trust income.

Non-interest expense increased 2% in the second quarter of 2007 versus the same period last year.  The increase for the second quarter reflected higher salaries and employee benefits, due in part to the addition of staff associated with the development of a second office in the Indianapolis market and the Company’s recently announced entry into the Cincinnati market, as well as higher data processing expense and net occupancy expense.  Non-interest expense declined 1% in the first half of 2007 compared with the year-earlier period.  For the year-to-date period of 2007, salaries and employee benefits were less than those of 2006 mainly due to lower health insurance expense, reduced stock compensation expense and deferral of salary expense related to loan originations.  Further, the first quarter of 2007 reflected a reduction in state bank taxes resulting from tax credits purchased in the quarter.  The Company’s efficiency ratio improved to 53.22% from 54.54% in the first quarter of 2007 and 53.88% in the second quarter last year.

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

a)             Results Of Operations

Net income of $6,297,000 for the three months ended June 30, 2007 increased $429,000, or 7%, from $5,868,000 for the comparable 2006 period.  Basic net income per share was $0.44 for the second quarter of 2007, an increase of 7% from the $0.41 for the same period in 2006.  Net income per share on a diluted basis was $0.43 for the second quarter of 2007 compared to $0.40 for the second quarter of 2006; an 8% increase.  Annualized return on average assets and annualized return on average stockholders’ equity were 1.80% and 17.90%, respectively, for the second quarter of 2007, compared to 1.76% and 18.02%, respectively, for the same period in 2006.

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Net income of $12,001,000 for the six months ended June 30, 2007 increased $813,000, or 7%, from $11,188,000 from the comparable 2006 period.  Basic net income per share was $0.84 for the first six months of 2007, an increase of 9% from the $0.77 for the same period in 2006.  Net income per share on a diluted basis was $0.82 for the first six months of 2007 compared to $0.76 for the first six months of 2006.  This represents an 8% increase.  Annualized return on average assets and annualized return on average stockholders’ equity were 1.72% and 17.26%, respectively, for the first six months of 2007, compared to 1.68% and 17.42%, respectively, for the same period in 2006.

Net Interest Income

The following tables present the average balance sheets for the three and six month periods ended June 30, 2007 and 2006 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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