10-Q 1 k65849e10-q.txt QUARTERLY REPORT U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File No. 000-26719 MERCANTILE BANK CORPORATION (Exact name of registrant as specified in its charter) Michigan 38-3360865 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 5650 BYRON CENTER AVENUE SW, WYOMING, MICHIGAN 49509 (Address of principal executive offices and zip code) (616) 406-3777 (Registrant's telephone number, including area code) 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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- At November 9, 2001, there were 4,722,702 shares of Common Stock outstanding. MERCANTILE BANK CORPORATION INDEX --------------------------------------------------------------------------------
PART I. Financial Information Page No. -------- Item 1. Financial Statements Consolidated Balance Sheets - September 30, 2001 (Unaudited) and December 31, 2000................................. 3 Consolidated Statements of Income - Three and Nine Months Ended September 30, 2001 (Unaudited) and September 30, 2000 (Unaudited)................................................... 4 Consolidated Statements of Changes in Shareholders' Equity - Nine months Ended September 30, 2001 (Unaudited) and September 30, 2000 (Unaudited)....................................................... 5 Consolidated Statements of Cash Flows - Three and Nine Months Ended September 30, 2001 (Unaudited) and September 30, 2000 (Unaudited)................................................... 6 Notes to Consolidated Financial Statements (Unaudited)................................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................. 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................... 22 PART II. Other Information Item 1. Legal Proceedings............................................................. 25 Item 2. Changes in Securities and Use of Proceeds..................................... 25 Item 3. Defaults upon Senior Securities............................................... 25 Item 4. Submission of Matters to a Vote of Security Holders........................... 25 Item 5. Other Information............................................................. 25 Item 6. Exhibits and Reports on Form 8-K.............................................. 25 Signatures............................................................................. 26
2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS MERCANTILE BANK CORPORATION CONSOLIDATED BALANCE SHEETS --------------------------------------------------------------------------------
September 30, December 31, 2001 2000 ------------- ------------- (Unaudited) ASSETS Cash and due from banks $ 18,206,017 $ 11,692,825 Short-term investments 156,782 108,846 Federal funds sold 5,100,000 6,300,000 ------------- ------------- Total cash and cash equivalents 23,462,799 18,101,671 Securities available for sale 47,343,818 45,147,493 Securities held to maturity (fair value of $23,985,943 at September 30, 2001 and $14,942,311 at December 31, 2000) 23,166,442 14,524,341 Federal Home Loan Bank stock 784,900 784,900 Total loans 540,691,940 429,804,105 Allowance for loan losses (7,929,830) (6,301,805) ------------- ------------- Total loans, net 532,762,110 423,502,300 Premises and equipment, net 8,410,282 4,119,385 Accrued interest receivable 3,066,267 2,758,054 Other assets 7,636,790 3,808,218 ------------- ------------- Total assets $ 646,633,408 $ 512,746,362 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest-bearing $ 39,891,409 $ 27,368,257 Interest-bearing 478,844,282 398,372,056 ------------- ------------- Total 518,735,691 425,740,313 Securities sold under agreements to repurchase 37,940,792 32,151,391 Other borrowed money 204,641 56,510 Accrued expenses and other liabilities 6,342,699 6,944,262 Guaranteed preferred beneficial interests in the Corporation's subordinated debentures 16,000,000 16,000,000 ------------- ------------- Total liabilities 579,223,823 480,892,476 Shareholders' equity Preferred stock, no par value; 1,000,000 shares authorized, none issued Common stock, no par value: 9,000,000 shares authorized; 4,722,702 shares outstanding at September 30, 2001 and 2,596,102 shares outstanding at December 31, 2000 61,807,269 29,935,401 Retained earnings 4,658,214 1,628,277 Accumulated other comprehensive income 944,102 290,208 ------------- ------------- Total shareholders' equity 67,409,585 31,853,886 ------------- ------------- Total liabilities and shareholders' equity $ 646,633,408 $ 512,746,362 ============= =============
-------------------------------------------------------------------------------- See accompanying notes to condensed consolidated financial statements. 3 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited) --------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 30, September 30, September 30, September 30, 2001 2000 2001 2000 ------------- ------------- ------------- ------------- Interest income Loans, including fees $ 10,340,809 $ 8,760,446 $ 29,766,854 $ 23,755,243 Investment securities 1,048,440 848,008 3,127,029 2,290,541 Federal funds sold 139,927 131,860 499,948 403,628 Short term investments 1,002 928 3,239 4,279 ------------- ------------- ------------- ------------- Total interest income 11,530,178 9,741,242 33,397,070 26,453,691 Interest expense Deposits 6,475,171 5,826,330 19,753,793 15,379,568 Short-term borrowings 307,634 388,634 948,996 961,117 Long-term borrowings 394,725 393,205 1,182,165 1,178,519 ------------- ------------- ------------- ------------- Total interest expense 7,177,530 6,608,169 21,884,954 17,519,204 ------------- ------------- ------------- ------------- NET INTEREST INCOME 4,352,648 3,133,073 11,512,116 8,934,487 Provisions to the allowance for loan losses 455,000 370,000 1,635,000 1,315,000 ------------- ------------- ------------- ------------- NET INTEREST INCOME AFTER PROVISIONS TO THE ALLOWANCE FOR LOAN LOSSES 3,897,648 2,763,073 9,877,116 7,619,487 Noninterest income Service charges on accounts 130,083 94,099 356,241 252,739 Interest rate swap termination fee 0 0 0 275,000 Net gain (loss) on sales of securities 0 0 99,594 (275,321) Other income 307,684 319,796 756,890 650,668 ------------- ------------- ------------- ------------- Total noninterest income 437,767 413,895 1,212,725 903,086 Noninterest expense Salaries and benefits 1,467,167 1,167,939 4,112,686 3,232,703 Occupancy 143,509 118,008 395,900 379,081 Furniture and equipment 123,581 112,075 335,030 330,727 Other expense 658,401 618,786 1,884,288 1,755,138 ------------- ------------- ------------- ------------- Total noninterest expenses 2,392,658 2,016,808 6,727,904 5,697,649 ------------- ------------- ------------- ------------- INCOME BEFORE FEDERAL INCOME TAX 1,942,757 1,160,160 4,361,937 2,824,924 Federal income tax expense 605,000 382,000 1,332,000 910,000 ------------- ------------- ------------- ------------- NET INCOME $ 1,337,757 $ 778,160 $ 3,029,937 $ 1,914,924 ============= ============= ============= ============= COMPREHENSIVE INCOME $ 1,839,121 $ 1,027,614 $ 3,683,831 $ 2,298,859 ============= ============= ============= ============= Basic earnings per share $ 0.33 $ 0.30 $ 0.92 $ 0.74 ============= ============= ============= ============= Diluted earnings per share $ 0.33 $ 0.30 $ 0.91 $ 0.74 ============= ============= ============= ============= Average basic shares outstanding 4,041,724 2,596,102 3,281,830 2,596,102 ============= ============= ============= ============= Average diluted shares outstanding 4,103,727 2,603,086 3,335,399 2,602,289 ============= ============= ============= =============
-------------------------------------------------------------------------------- See accompanying notes to condensed consolidated financial statements. 4 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) --------------------------------------------------------------------------------
Accumulated Retained Other Total Common Earnings Comprehensive Shareholders' Stock (Deficit) Income (Loss) Equity ----------------- ----------------- ----------------- ----------------- BALANCE, JANUARY 1, 2000 $ 28,181,798 $ 587,639 $ (801,568) $ 27,967,869 Comprehensive income: Net income for the period from January 1, 2000 through September 30, 2000 1,914,924 1,914,924 Change in net unrealized gain (loss) on securities available for sale, net of tax effect 383,935 383,935 ----------------- Total comprehensive income 2,298,859 ----------------- ----------------- ----------------- ----------------- BALANCE, SEPTEMBER 30, 2000 $ 28,181,798 $ 2,502,563 $ (417,633) $ 30,266,728 ================= ================= ================= ================= BALANCE, JANUARY 1, 2001 $ 29,935,401 $ 1,628,277 $ 290,208 $ 31,853,886 Comprehensive income: Net income for the period from January 1, 2001 through September 30, 2001 3,029,937 3,029,937 Change in net unrealized gain (loss) on securities available for sale, net of tax effect 653,894 653,894 ----------------- Total comprehensive income 3,683,831 ----------------- Common stock sales, net proceeds 31,871,868 31,871,868 ----------------- ----------------- ----------------- ----------------- BALANCE, SEPTEMBER 30, 2001 $ 61,807,269 $ 4,658,214 $ 944,102 $ 67,409,585 ================= ================= ================= =================
-------------------------------------------------------------------------------- See accompanying notes to condensed consolidated financial statements. 5 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) --------------------------------------------------------------------------------
Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 30, September 30, September 30, September 30, 2001 2000 2001 2000 ------------- ------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 1,337,757 $ 778,160 $ 3,029,937 $ 1,914,924 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 166,118 143,202 367,542 439,285 Provision for loan losses 455,000 370,000 1,635,000 1,315,000 Net (gain) loss on sales of available for sale securities 0 0 (99,594) 275,321 Net change in: Accrued interest receivable (322,673) (355,731) (308,213) (695,994) Other assets (581,054) (207,583) (4,286,373) (561,034) Accrued expenses and other liabilities 23,656 1,909,838 (601,563) 3,643,804 ------------- ------------- ------------- ------------- Net cash from operating activities 1,078,804 2,637,886 (263,264 6,331,306 CASH FLOWS FROM INVESTING ACTIVITIES Net increase in loans (32,568,655) (26,069,716) (110,894,810) (93,087,196) Purchase of: Securities available for sale (3,009,027) (2,981,900) (20,178,843) (14,863,539) Securities held to maturity (3,368,217) (835,248) (8,748,055) (5,598,550) Premises and equipment (2,283,978) (753,953) (4,628,788) (895,317) Proceeds from: Sales of available for sale securities 0 0 5,361,961 6,718,120 Maturities, calls and repayments of available for sale securities 3,469,509 871,376 13,806,649 2,632,919 Maturities, calls and repayments of held to maturity securities 0 0 101,500 0 ------------- ------------- ------------- ------------- Net cash from investing activities (37,760,368) (29,769,441) (125,180,386) (105,093,563) CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits (1,486,355) 28,179,519 92,995,378 94,963,390 Net proceeds from the sale of common stock 25,123,149 0 31,871,868 0 Net increase in other borrowed money 93,014 13,614 148,131 33,850 Net increase in securities sold under agreements to repurchase 3,153,149 4,591,576 5,789,401 7,062,135 ------------- ------------- ------------- ------------- Net cash from financing activities 26,882,957 32,784,709 130,804,778 102,059,375 ------------- ------------- ------------- ------------- Net change in cash and cash equivalents (9,798,607) 5,653,154 5,361,128 3,297,118 Cash and cash equivalents at beginning of period 33,261,406 11,294,320 18,101,671 13,650,356 ------------- ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 23,462,799 $ 16,947,474 $ 23,462,799 $ 16,947,474 ============= ============= ============= ============= Supplemental disclosures of cash flow information Cash paid during the year for Interest $ 7,316,872 $ 5,044,407 $ 22,333,536 $ 14,044,512 Federal income tax 475,000 375,000 1,863,110 1,167,000 Cash received during the year for Interest rate swap termination fee 0 0 0 275,000
-------------------------------------------------------------------------------- See accompanying notes to condensed consolidated financial statements. 6 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION: The unaudited financial statements for the three and nine months ended September 30, 2001 include the consolidated results of operations of Mercantile Bank Corporation and its wholly-owned subsidiaries, Mercantile Bank of West Michigan ("our bank") and MBWM Capital Trust I ("the trust"), and of Mercantile Bank Mortgage Company ("our mortgage company"), a wholly-owned subsidiary of our bank. These consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Item 303(b) of Regulation S-K and do not include all disclosures required by generally accepted accounting principles for a complete presentation of our financial condition and results of operations. In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) which are necessary in order to make the financial statements not misleading and for a fair presentation of the results of operations for such periods. The results for the period ended September 30, 2001 should not be considered as indicative of results for a full year. For further information, refer to the consolidated financial statements and footnotes included in the company's annual report on Form 10-K for the year ended December 31, 2000. 2. LOANS Our total loans at September 30, 2001 were $540.7 million compared to $429.8 million at December 31, 2000, an increase of $110.9 million or 25.8%. The components of the outstanding balances and percentage increase in loans from the end of 2000 to the end of the third quarter 2001 are as follows:
Percent September 30, 2001 December 31, 2000 Increase/ Balance % Balance % (Decrease) ------------- ------------- ------------- ------------- ------------- (dollars in thousands) Real Estate: Construction and land development $ 53,797 9.9% $ 38,815 9.0% 38.6% Secured by 1-4 family properties 39,270 7.3 33,709 7.8 16.5 Secured by multi-family properties 1,481 0.3 2,127 0.5 (30.4) Secured by nonfarm nonresidential properties 248,312 45.9 197,018 45.9 26.0 Commercial 190,466 35.2 151,344 35.2 25.8 Consumer 7,366 1.4 6,791 1.6 8.5 ------------- ------------- ------------- ------------- ------------- $ 540,692 100.0% $ 429,804 100.0% 25.8% ============= ============= ============= ============= =============
-------------------------------------------------------------------------------- (Continued) 7 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 3. ALLOWANCE FOR LOAN LOSSES The following is a summary of the activity in our allowance for loan losses account for the three months ended September 30:
2001 2000 ------------ ------------ Balance at July 1 $ 7,462,092 $ 5,527,485 Charge-offs 0 (3,389) Recoveries 12,738 2,400 Provision to the allowance for loan losses 455,000 370,000 ------------ ------------ Balance at September 30 $ 7,929,830 $ 5,896,496 ============ ============
The following is a summary of the activity in our allowance for loan losses account for the nine months ended September 30:
2001 2000 ----------- ----------- Balance at January 1 $ 6,301,805 $ 4,620,469 Charge-offs (64,831) (49,773) Recoveries 57,856 10,800 Provision to the allowance for loan losses 1,635,000 1,315,000 ----------- ----------- Balance at September 30 $ 7,929,830 $ 5,896,496 =========== ===========
4. PREMISES AND EQUIPMENT - NET Premises and equipment are comprised of the following:
September 30, December 31, 2001 2000 ------------- ------------- Land and improvements $ 1,173,165 $ 1,134,548 Buildings and leasehold improvements 5,019,469 2,128,353 Construction in process 881,818 220,797 Furniture and equipment 2,624,433 1,586,621 ------------- ------------- 9,698,885 5,070,319 Less accumulated depreciation 1,288,603 950,934 ------------- ------------- Premises and Equipment, net $ 8,410,282 $ 4,119,385 ============= =============
Depreciation expense amounted to $121,939 during the second quarter of 2001 and $337,891 during the first nine months of 2001. -------------------------------------------------------------------------------- (Continued) 8 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 5. DEPOSITS Our total deposits at September 30, 2001 were $518.7 million compared to $425.7 million at December 31, 2000, an increase of $93.0 million, or 21.8%. The components of our outstanding balances at September 30, 2001 and December 31, 2000, and percentage increase in deposits from the end of 2000 to the end of the third quarter 2001 are as follows:
Percent September 30, 2001 December 31, 2000 Increase/ Balance % Balance % (Decrease) ------------- ------------- ------------- ------------- ------------- (dollars in thousands) Noninterest-bearing demand $ 39,892 7.7% $ 27,368 6.4% 45.8% Interest-bearing checking 16,899 3.2 12,968 3.1 30.3 Money market 5,068 1.0 5,196 1.2 (2.5) Savings 43,583 8.4 36,331 8.6 20.0 Time, under $100,000 6,444 1.2 6,165 1.4 4.5 Time, $100,000 and over 51,175 9.9 38,682 9.1 32.3 ------------- ------------- ------------- ------------- ------------- 163,061 31.4 126,710 29.8 28.7 Out-of-area time, under $100,000 82,590 15.9 55,260 13.0 49.5 Out-of-area time, $100,000 and over 273,085 52.7 243,770 57.2 12.0 ------------- ------------- ------------- ------------- ------------- 355,675 68.6 299,030 70.2 18.9 ------------- ------------- ------------- ------------- ------------- Total Deposits $ 518,736 100.0% $ 425,740 100.0% 21.8% ============= ============= ============= ============= =============
6. BORROWINGS Information relating to our securities sold under agreements to repurchase follows:
September 30, December 31, 2001 2000 ------------- ------------- Outstanding balance at end of period $ 37,940,792 $ 32,151,391 Average interest rate at end of period 3.49% 4.63% Average balance during the period $ 33,283,470 $ 29,190,780 Average interest rate during the period 4.28% 4.66% Maximum month end balance during the period $ 40,060,845 $ 35,473,498
Securities sold under agreements to repurchase (repurchase agreements) generally have original maturities of less than one year. Repurchase agreements are treated as financings and the obligations to repurchase securities sold are reflected as liabilities. Securities involved with the agreements are recorded as assets of our bank and are primarily held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain large deposit customers as deposit equivalent investments. -------------------------------------------------------------------------------- (Continued) 9 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 7. COMMITMENTS AND OFF-BALANCE-SHEET RISK Our bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan 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. Standby letters of credit are conditional commitments issued by our bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. Our bank's maximum exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. Our bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Collateral, such as accounts receivable, securities, inventory, property and equipment, is generally obtained based on management's credit assessment of the borrower. A summary of the notional or contractual amounts of our financial instruments with off-balance-sheet risk at September 30, 2001 and December 31, 2000 follows:
September 30, December 31, 2001 2000 ------------- ------------- Commercial unused lines of credit $ 120,110,848 $ 87,121,094 Unused lines of credit secured by 1-4 family residential properties 8,617,569 7,641,057 Credit card unused lines of credit 5,907,353 4,578,325 Other consumer unused lines of credit 3,787,403 2,062,084 Commitments to make loans 26,570,800 20,110,500 Standby letters of credit 38,474,347 36,889,288 ------------- ------------- $ 203,468,320 $ 158,402,348 ============= =============
8. REGULATORY MATTERS We are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. -------------------------------------------------------------------------------- (Continued) 10 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 8. REGULATORY MATTERS (Continued) The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required Our actual capital levels (dollars in thousands) and minimum required levels were:
Minimum Required to be Well Minimum Required Capitalized Under for Capital Prompt Corrective Actual Adequacy Purposes Action Regulations ---------------------------- ---------------------------- ---------------------------- Amount Ratio Amount Ratio Amount Ratio ------------ ------------ ------------ ------------ ------------ ------------ September 30, 2001 ------------------ Total capital (to risk weighted assets) Consolidated $ 90,268 14.5% $ 49,933 8.0% $ 62,416 10.0% Bank 87,615 14.1 49,767 8.0 62,208 10.0 Tier 1 capital (to risk weighted assets) Consolidated 82,465 13.2 24,972 4.0 37,457 6.0 Bank 79,837 12.8 24,890 4.0 37,334 6.0 Tier 1 capital (to average assets) Consolidated 82,465 13.1 25,245 4.0 31,556 5.0 Bank 79,837 12.7 25,163 4.0 31,454 5.0 December 31, 2000 ----------------- Total capital (to risk weighted assets) Consolidated $ 53,685 11.0% $ 39,163 8.0% $ 48,953 10.0% Bank 51,596 10.6 39,017 8.0 48,771 10.0 Tier 1 capital (to risk weighted assets) Consolidated 42,085 8.6 19,589 4.0 29,383 6.0 Bank 45,497 9.3 19,517 4.0 29,275 6.0 Tier 1 capital (to average assets) Consolidated 42,085 8.6 19,601 4.0 24,502 5.0 Bank 45,497 9.3 19,528 4.0 24,410 5.0
We were categorized as well capitalized at September 30, 2001 and year-end 2000. -------------------------------------------------------------------------------- (Continued) 11 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) -------------------------------------------------------------------------------- 8. REGULATORY MATTERS (Continued) During the third quarter of 2001 we sold 1,610,000 shares of common stock in an underwritten public offering, raising $25.2 million in net proceeds. During the first quarter of 2001 we sold a combined 516,600 shares of common stock in two private placement offerings, raising $6.7 million in net proceeds. We contributed substantially all of the net proceeds to our bank as capital. The trust sold 1.6 million Cumulative Preferred Securities ("trust preferred securities") at $10.00 per trust preferred security in a September 1999 offering. The proceeds from the sale were used by the trust to purchase an equivalent amount of subordinated debentures from the company. The trust preferred securities carry a fixed rate of 9.60%, have a stated maturity of 30 years, and, in effect, are guaranteed by the company. The securities are redeemable at par after 5 years. Distributions on the trust preferred securities are payable quarterly on January 15, April 15, July 15, and October 15. The first distribution was paid on October 15, 1999. Under certain circumstances, distributions may be deferred for up to 20 calendar quarters. However, during any such deferrals, interest accrues on any unpaid distributions at the rate of 9.60% per annum. Our capital levels as of September 30, 2001 include an adjustment for the 1.6 million trust preferred securities issued by the trust. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in our Tier 1 capital to 25% of total Tier 1 capital. As of September 30, 2001, the entire $16.0 million of the trust preferred securities were included as Tier 1 capital. Our and our bank's ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. We declared a 5% stock dividend on January 10, 2001, that was paid on February 1, 2001 to record holders as of January 19, 2001. We have not paid cash dividends on our common stock since our formation in 1997, and we currently have no intention of doing so in the foreseeable future. -------------------------------------------------------------------------------- 12 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS This report contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about our company. Words such as "anticipates", "believes", "estimates", "expects", "forecasts", "intends", "is likely", "plans", "projects", variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise. Future Factors include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; and changes in the national and local economy. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement. INTRODUCTION The following discussion compares the financial condition of Mercantile Bank Corporation and its wholly-owned subsidiaries, Mercantile Bank of West Michigan ("our bank") and MBWM Capital Trust I ("the trust"), and of Mercantile Bank Mortgage Company ("our mortgage company"), a wholly-owned subsidiary of our bank, at September 30, 2001 to December 31, 2000 and the results of operations for the three and nine months ended September 30, 2001 and September 30, 2000. This discussion should be read in conjunction with the interim consolidated condensed financial statements and footnotes included herein. Unless the text clearly suggests otherwise, references in this report to "us," "we," "our," or "the company" include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above. Subsequent to September 30, 2001, our bank filed a license application with the Michigan Office of Financial and Insurance Services to operate a new subsidiary as a Michigan Business and Industrial Development Company under the name Mercantile BIDCO, Inc. When approved Mercantile BIDCO, Inc., a non-depository Michigan financial institution, expects to offer equipment lease financing, asset based loans, junior debt facilities and other financing where equity features may be part of the facility pricing. During the past year, we were engaged in preliminary discussions with several unaffiliated financial institutions to explore the possibility of an acquisition by us. To date the discussions have been exploratory in nature and no likely candidate has been identified. We expect that such discussions may occur from time-to-time with these or other financial institutions in future periods. -------------------------------------------------------------------------------- (Continued) 13 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- FINANCIAL CONDITION During the first nine months of 2001, our assets increased from $512.7 million on December 31, 2000, to $646.6 million on September 30, 2001. This represents a total increase in assets of $133.9 million, or 26.1%. The asset growth was comprised primarily of a $109.3 million increase in net loans, a $10.8 million increase in investment securities and a $5.4 million increase in cash and cash equivalents. The increase in assets was primarily funded by a $93.0 million growth in deposits and an increase of $5.8 million in securities sold under agreements to repurchase, along with the receipt of $31.9 million in net proceeds from our sales of common stock. Commercial loans increased by $104.8 million during the first nine months of 2001, and at September 30, 2001 totaled $494.1 million, or 91.4% of the total loan portfolio. The continued significant concentration of the loan portfolio in commercial loans and the rapid growth of this portion of business is consistent with our stated strategy of focusing a substantial amount of efforts on "wholesale" banking. Corporate and business lending continues to be an area of expertise of our senior management team, and our eight commercial lenders have over 110 years of combined commercial lending experience. Of each of the loan categories that we originate, commercial loans are the most efficiently originated and managed, thus reducing overhead by necessitating the attention of fewer employees. Our commercial lending business generates the greatest amount of local deposits, and is virtually the only source of significant demand deposits. Residential mortgage and consumer loans also increased by $5.6 million and $0.6 million, respectively, during the first nine months of 2001. As of September 30, 2001, these loan types totaled a combined $46.6 million, or 8.6% of the total loan portfolio. Although the residential mortgage loan and consumer loan portfolios are expected to increase in future periods, given our wholesale banking strategy, the commercial sector of the lending efforts and resultant assets are expected to remain the dominant loan portfolio category. The quality of our loan portfolio remains strong. Net loan charge-offs during the first nine months of 2001 totaled $6,975, or less than 0.01% of average total loans. Past due loans and nonaccrual loans at September 30, 2001 totaled $880,562, or only 0.16% of total loans. We believe we have instilled a very strong credit culture within our lending departments as it pertains to the underwriting and administration processes, which in part is reflected in our loan charge-off and delinquency ratios. Over 97% of the loan portfolio consists of loans extended directly to companies and individuals doing business and residing within our market area. The remaining portion is comprised of commercial loans participated with certain non-affiliated commercial banks outside the immediate area, which are underwritten using the same loan criteria as though our bank was the originating bank. Net premises and fixed assets have increased from $4.1 million on December 31, 2000, to $8.4 million on September 30, 2001. The increase is primarily attributable to the construction of two facilities on a 4-acre parcel of land located in the city of Wyoming, a southwest suburb of Grand Rapids. We acquired the land in 2000. The larger of the two buildings, a two-story facility with approximately 25,000 square feet of usable space, serves as the new location for our operations and accounting departments and includes a full service branch. This facility opened in September, 2001. The other building, a single story facility with approximately 7,000 square feet of usable space, accommodates our administration function. This facility opened in October, 2001. The cost of the facilities, including land, totals about $5.5 million. -------------------------------------------------------------------------------- (Continued) 14 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Other assets increased from $3.8 million on December 31, 2000, to $7.6 million on September 30, 2001. The increase is primarily attributable to our purchase of bank owned life insurance policies for selected officers. These single premium insurance policies, that include term insurance coverage, were purchased mainly to provide funding for our non-qualified deferred compensation plan made available to selected officers. It is estimated that the cash surrender value of each of the individual insurance policies will approximate the ending balance in the deferred compensation plan of each of the respective officers upon them reaching retirement age. Deposits increased $93.0 million during the first nine months of 2001, totaling $518.7 million at September 30, 2001. Local deposits increased $36.4 million, or 28.7%, while out-of-area deposits increased $56.6 million, or 18.9%. As a percent of total deposits, local deposits increased from 29.8% on December 31, 2000, to 31.4% on September 30, 2001. Noninterest-bearing demand deposits, comprising 7.7% of total deposits, increased $12.5 million during the first nine months of 2001. Savings deposits (8.4% of total deposits) increased $7.3 million, and interest-bearing checking deposits (3.2% of total deposits) increased $3.9 million during the first nine months of 2001. Money market deposit accounts (1.0% of total deposits) decreased by $0.1 million during the first nine months of 2001. Local certificates of deposit, comprising 11.1% of total deposits, increased by $12.8 million during the first nine months of 2001. Out-of-area deposits totaled $355.7 million, or 68.6% of total deposits, as of September 30, 2001. Out-of-area deposits consist primarily of certificates of deposit obtained from depositors located outside the market area and placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. Out-of-area deposits are utilized to support our asset growth, and are generally a lower cost source of funds when compared to the interest rates that would have to be offered in the local market to generate a sufficient level of funds. During the first nine months of 2001 rates paid on new out-of-area certificates of deposit were very similar to rates paid on new certificates of deposit issued to local customers. In addition, the overhead costs associated with the out-of-area deposits are considerably less than the overhead costs that would be incurred to administer a similar level of local deposits. While the business plan anticipated the reliance on out-of-area deposits in the early stages of our development, our longer-term strategy for funding is to increase local deposits and lower our reliance on out-of-area deposits. Although local deposits have and are expected to increase as new business, governmental and consumer deposit relationships are established and as existing customers increase their deposit accounts, the relatively high reliance on out-of-area deposits will likely remain. Securities sold under agreements to repurchase ("repurchase agreements") increased by $5.8 million during the first nine months of 2001. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested into over-night interest-bearing repurchase agreements. Although not considered a deposit account and therefore not afforded federal deposit insurance, the repurchase agreements have characteristics very similar to that of our business checking deposit accounts. LIQUIDITY Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans and support our operations. Liquidity is primarily achieved through the growth of deposits (both local and out-of-area) and liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. -------------------------------------------------------------------------------- (Continued) 15 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Our liquidity strategy is to fund loan growth with deposits and repurchase agreements and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity. Although deposit and repurchase agreement growth from depositors located in the market area have consistently increased, the growth has not been sufficient to meet the substantial loan growth and provide monies for additional investing activities. To assist in providing the additional needed funds, we have regularly obtained certificates of deposit from customers outside of the market area and placed by deposit brokers for a fee, as well as certificates of deposit obtained from the deposit owners directly. As of September 30, 2001, out-of-area deposits totaled $355.7 million, or 63.9% of combined deposits and repurchase agreements, compared to $299.0 million, or 65.3% of combined deposits and repurchase agreements, as of December 31, 2000. Reliance on out-of-area deposits is expected to be ongoing due to our planned future growth. Our bank has the ability to borrow money on a daily basis through correspondent banks via established federal funds purchased lines; however, this is viewed as only a secondary and temporary source of funds. The federal funds purchased lines were utilized for only one business day during the first nine months of 2001. Our bank's federal funds sold position averaged $15.0 million, or 2.6% of average assets, during the first nine months of 2001. In addition, as a member of the Federal Home Loan Bank of Indianapolis ("FHLBI"), our bank has access to the FHLBI's borrowing programs. Based on ownership of FHLBI stock and available collateral at September 30, 2001, the Bank could borrow up to about $15.0 million. Our bank has yet to use its established borrowing line at the FHLBI. We have also been extended a $10.0 million unsecured line of credit from a correspondent bank. Proceeds from the credit facility may be used for working capital, investment in our bank or acquisition of financial institutions. The line, which has yet to be utilized, matures on February 27, 2002. In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of September 30, 2001, our bank had a total of $165.0 million in unfunded loan commitments and $38.5 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $138.4 million were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and $26.6 million were for loan commitments scheduled to close and become funded within the next three months. We monitor fluctuations in loan balances and commitment levels, and include such data in managing overall liquidity. CAPITAL RESOURCES Shareholders' equity is a noninterest-bearing source of funds that provides support for asset growth. Shareholders' equity was $67.4 million and $31.9 million at September 30, 2001 and December 31, 2000, respectively. The increase during the first nine months of 2001 is primarily attributable to the sale of common stock and net income. During the first quarter we sold a total of 516,600 shares of common stock in two private placement offerings, raising $6.7 million in net proceeds. During the third quarter we sold 1,610,000 shares of common stock in an underwritten public offering, raising $25.2 million in net proceeds. We contributed substantially all of the net proceeds to our bank as capital. Net income equaled $3.0 million during the first nine months of 2001. In addition, shareholders' equity was also positively impacted during the first nine months of 2001 by a $0.7 million mark-to-market adjustment for available for sale securities as defined in SFAS No. 115. The adjustment was due to the decline in the interest rate environment during the first nine months of 2001. -------------------------------------------------------------------------------- (Continued) 16 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- In September 1999 the company, through the trust, issued 1.6 million shares of trust preferred securities at $10.00 per share. Substantially all of the net proceeds were contributed to our bank as capital and were used to support growth in assets, fund investments in loans and securities, and for general corporate purposes. Although not part of shareholder's equity, subject to certain limitations the trust preferred securities are considered a component of capital for purposes of calculating regulatory capital ratios. At September 30, 2001, the entire $16.0 million of trust preferred securities were included as Tier 1 capital. We are subject to regulatory capital requirements administered by the State of Michigan and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Since our bank commenced operations, both the company and our bank have been categorized as "Well Capitalized," the highest classification contained within the banking regulations. The capital ratios of the company and our bank as of September 30, 2001 and December 31, 2000 are disclosed under Note 8 of the Notes to Consolidated Financial Statements. Our and the bank's ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. We declared a 5% stock dividend on January 10, 2001, which was paid on February 1, 2001 to record holders as of January 19, 2001. We have not paid cash dividends on our common stock since our formation in 1997, and we currently have no intention of doing so in the foreseeable future. RESULTS OF OPERATIONS Net income for the third quarter of 2001 was $1,337,757 ($0.33 per basic and diluted share), which represents a 71.9% increase over net income of $778,160 ($0.30 per basic and diluted share) recorded during the third quarter of 2000. The 10.0% growth in basic and diluted earnings per share was less than the 71.9% increase in the dollar volume of net income due to the dilution impact of the common stock sales during the first and third quarters of 2001. Net income for the first nine months of 2001 was $3,029,937 ($0.92 per basic share and $0.91 per diluted share), which represents a 58.2% increase over net income of $1,914,924 ($0.74 per basic and diluted share) recorded during the first nine months of 2000. The 23.0% growth in diluted earnings per share was less than the 58.2% increase in the dollar volume of net income due to the dilution impact of the common stock sales during the first and third quarters of 2001. The improvement in net income during both time periods is primarily the result of an increase in net interest income, higher noninterest income and greater employee efficiency. Interest income during the third quarter of 2001 was $11,530,178, an increase of 18.4% over the $9,741,242 earned during the third quarter of 2000. Interest income during the first nine months of 2001 was $33,397,070, an increase of 26.2% over the $26,453,691 earned during the first nine months of 2000. The growth in interest income during both time periods is primarily attributable to an increase in earning assets. During the third quarter of 2001 earning assets averaged $607.0 million, a level substantially higher than the average earning assets of $447.7 million during the third quarter of 2000. Increase in total loans and investment securities accounted for 84.6% and 10.7% of the growth in average earnings assets, respectively. During the first nine months of 2001 earning assets averaged $562.1 million, a level significantly higher than the average earning assets of $416.5 million during the same time period in 2000. Increase in total loans and investment securities accounted for 83.3% and 12.4% of the growth in average earnings assets, respectively. -------------------------------------------------------------------------------- (Continued) 17 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Negatively impacting the growth in interest income during the third quarter of 2001 and the first nine months of 2001 was the decline in yield on earning assets. During the third quarter of 2001 and 2000, earning assets had a weighted average yield of 7.61% and 8.81%, respectively. During the first nine months of 2001 and 2000 earning assets had a weighted average yield of 7.65% and 8.51%, respectively. The decrease in weighted average yields is primarily due to the overall decline in market interest rates during the first nine months of 2001, in part evidenced by the 375 basis point drop in the prime rate since January 3, 2001. Interest expense during the third quarter of 2001 was $7,177,530, an increase of 8.6% over the $6,608,169 expensed during the third quarter of 2000. Interest expense during the first nine months of 2001 was $21,884,954, an increase of 24.9% over the $17,519,204 expensed during the first nine months of 2000. The growth in interest expense is primarily attributable to the growth in assets, which necessitated an increase in funding liabilities. During the third quarter of 2001, interest-bearing liabilities averaged $535.1 million, a level substantially higher than average interest-bearing funds of $402.7 million during the third quarter of 2000. During the first nine months of 2001, interest-bearing liabilities averaged $501.3 million, a level substantially higher than average interest-bearing funds of $373.6 million during the same time period in 2000. Positively impacting the growth in interest expense during the third quarter of 2001 and the first nine months of 2001 was the decline in the cost of interest-bearing funds. During the third quarter of 2001 and 2000, interest-bearing liabilities had a weighted average rate of 5.32% and 6.52%, respectively. During the first nine months of 2001 and 2000 interest-bearing liabilities had a weighted average rate of 5.84% and 6.25%, respectively. The decrease in cost of interest-bearing liabilities is primarily due to the overall decline in market interest rates. Net interest income during the third quarter of 2001 was $4,352,648, an increase of 38.9% over the $3,133,073 earned during the third quarter of 2000. Net interest income during the first nine months of 2001 was $11,512,116, an increase of 28.9% over the $8,934,487 earned during the same time period in 2000. The net interest margin increased from 2.85% during the third quarter of 2000 to 2.92% in third quarter of 2001, but declined from 2.95% during the first nine months of 2000 to 2.81% in the first nine months of 2001. The decline is primarily due to the rapid decline in market interest rates that occurred during the first nine months of 2001 and our vulnerability to such an event in the short term horizon. The level of loans tied to the prime rate is approximately double the level of non-certificate of deposit funding products. As a result, and despite the fact that most of the major interest rate indices have declined in a similar manner to that of the prime rate, each time market interest rates have declined our net interest margin has been negatively impacted. However, this repricing gap is short term in nature. As interest rates stabilize or decline at a slower pace and/or magnitude, and a significant volume of local and out-of-area certificates of deposit mature and reprice to much lower rates, it is expected that the net interest margin would be positively impacted. In fact, the third quarter of 2001 net interest margin of 2.92% was significantly higher than the net interest margin for the second quarter of 2001 of 2.73% due in part to the slower pace and magnitude of interest rate declines. Also benefiting the third quarter net interest margin was the $25.2 million in net proceeds we received in August from the sale of common stock. If interest rates continue to stabilize or decline at a slower pace and/or magnitude, and as local and out-of-area certificates of deposit continue to mature and reprice to much lower rates, we expect our net interest margin to improve throughout the remainder of 2001 and into 2002. This expectation is further supported by the results of the net interest income simulation analysis completed as of September 30, 2001, as presented and discussed under the heading "Item 3 Quantitative and Qualitative Disclosures About Market Risk" starting on page 22. -------------------------------------------------------------------------------- (Continued) 18 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- The following table sets forth certain information relating our consolidated average interest earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the third quarter of 2001 and 2000. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. For tax-exempt securities interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 34%.
Quarters ended September 30, ----------------------------------------------------------------------------------------------- 2001 2000 --------------------------------------------- --------------------------------------------- Average Average Average Average Balance Interest Rate Balance Interest Rate ------------ ------------ ------------ ------------ ------------ ------------ (dollars in thousands) ASSETS Loans $ 522,615 $ 10,341 7.85% $ 387,793 $ 8,760 8.96% Investment securities 68,902 1,162 6.75 51,782 915 7.06 Federal funds sold 15,376 140 3.56 8,010 132 6.58 Short term investments 143 1 2.79 74 1 5.45 ------------ ------------ ------------ ------------ ------------ ------------ Total interest-earning assets 607,036 11,644 7.61 447,659 9,808 8.81 Allowance for loan losses (7,704) (5,722) Other assets 31,592 19,498 ------------ ------------ Total assets $ 630,924 $ 461,435 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits $ 482,430 6,475 5.32 $ 355,293 5,826 6.10 Short-term borrowings 36,427 308 3.35 31,366 389 4.92 Long-term borrowings 16,161 395 9.70 16,040 393 9.79 ------------ ------------ ------------ ------------ ------------ ------------ Total interest-bearing liabilities 535,018 7,178 5.32 402,699 6,608 6.52 Noninterest-bearing deposits 34,138 23,427 Other liabilities 5,935 5,418 Shareholders' equity 55,833 29,891 ------------ ------------ ------------ ------------ ------------ ------------ Total liability and shareholders' equity $ 630,924 $ 461,435 ============ ============ Net interest income $ 4,466 $ 3,200 ============ ============ Net interest rate spread 2.29% 2.29% ============ ============ Net interest rate spread on average assets 2.81% 2.76% ============ ============ Net interest margin on earning assets 2.92% 2.85% ============ ============
Provisions to the allowance for loan losses during the third quarter of 2001 were $455,000, an increase from the $370,000 expensed during the same time period in 2000. Provisions to the allowance for loan losses during the first nine months of 2001 were $1,635,000, an increase from the $1,315,000 expensed during the same time period in 2000. The increase during both time periods reflects the higher volume of loan growth. We had no loan charge-offs during the third quarter of 2001, but did recognize $12,739 in recoveries from prior loan charge-offs. During the third quarter of 2000 net loan charge-offs totaled only $989. During the first nine months of 2001 net loan charge-offs totaled only $6,975 compared to net loan charge-offs of only $38,973 during the same time period in 2000. The allowance for loan losses as a percentage of total loans outstanding as of September 30, 2001 was 1.47%, unchanged from the level at December 31, 2000. -------------------------------------------------------------------------------- (Continued) 19 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- In each accounting period, the allowance for loan losses is adjusted to the amount believed necessary to maintain the allowance for loan losses at adequate levels. Through the loan review and credit departments, we attempt to allocate specific portions of the allowance for loan losses based on specifically identifiable problem loans. The evaluation of the allowance for loan losses is further based on, although not limited to, consideration of the internally prepared Loan Loss Reserve Analysis ("Reserve Analysis"), composition of the loan portfolio, third party analysis of the loan administration processes and loan portfolio and general economic conditions. In addition, our bank's status as a relatively new banking organization and the rapid loan growth since inception is taken into account. The Reserve Analysis, used since the inception of our bank and completed monthly, applies reserve allocation factors to outstanding loan balances to calculate an overall allowance dollar amount. For commercial loans, which continue to comprise a vast majority of our total loans, reserve allocation factors are based upon the loan ratings as determined by our comprehensive loan rating paradigm that is administered by our loan review function. For retail loans, reserve allocation factors are based upon the type of credit. The reserve allocation factors are based on the experience of senior management making similar loans in the same community over the past 15 years. The Reserve Analysis is reviewed regularly by senior management and the Board of Directors and is adjusted periodically based upon identifiable trends and experience. Noninterest income during the third quarter of 2001 was $437,767, an increase of 5.8% over the $413,895 earned during the same time period in 2000. Noninterest income, excluding the net gains on sales of securities, during the first nine months of 2001 was $1,113,131, an increase of 23.3% over the $903,086 earned during the same time period in 2000. Service charge income on deposits and repurchase agreements increased $35,984 (38.2%) during the third quarter of 2001 over that earned in the third quarter of 2000, and during the first nine months of 2001 increased $103,502 (41.0%) over that earned in the comparable time period in 2000. The strong increases during both time periods primarily results from new accounts opened during the last 12 months. Reflecting declining interest rates and the resulting increase in residential mortgage loan refinancings, fees earned on referring residential mortgage loan applicants to various third parties increased $23,932 (55.7%) during the third quarter of 2001 over that earned during the third quarter of 2000, and increased $133,454 (119.3%) during the first nine months of 2001 over that earned during the first nine months of 2000. Reflecting the reduction in letter of credit issuances and resulting origination fees, letter of credit fees decreased $73,142 (34.5%) during the third quarter of 2001 over that earned during the third quarter of 2000, and were down $38,450 (11.7%) during the first nine months of 2001 when compared to the first nine months of 2000. Noninterest expense during the third quarter of 2001 was $2,392,658, an increase of 18.6% over the $2,016,808 expensed during the same time period in 2000. Noninterest expense during the first nine months of 2001 was $6,727,904, an increase of 18.1% over the $5,697,649 expensed during the same time period in 2000. An increase in all major overhead cost categories was recorded, but was primarily related to salaries and benefits and general overhead costs. The increases in salaries and benefits primarily resulted from the hiring of additional staff and annual pay increases. General overhead costs have also increased reflecting the additional expenses required to administer our significantly increased assets. -------------------------------------------------------------------------------- (Continued) 20 MERCANTILE BANK CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- While the dollar volume of noninterest costs have increased, as a percent of average assets the level has substantially declined as a result of our growth and the realization of operating efficiencies. During the third quarter of 2001 noninterest costs were 1.50% of average assets on an annualized basis, a decline from the 1.72% level during the same time period in 2000. During the first nine months of 2001, noninterest costs were 1.55% of average assets on an annualized basis, a decline from the 1.77% level during the same time period in 2000. Monitoring and controlling noninterest costs, while at the same time providing high quality service to customers, is one of our priorities. Our efficiency ratio, computed by dividing noninterest expenses by net interest income plus noninterest income, was 50.0% and 52.9% during the third quarter and first nine months of 2001, respectively. These levels compare favorably to our efficiency ratio 56.9% and 57.9% during the third quarter and first nine months of 2000, respectively. A higher level of net revenue growth (net interest income plus noninterest expense) when compared to the growth in overhead costs has led to improved efficiency ratios and overall profitability. Federal income tax expense was $605,000 and $1,332,000 during the third quarter and first nine months of 2001, respectively. Federal income tax expense was $382,000 and $910,000 during the third quarter and first nine months of 2000, respectively. -------------------------------------------------------------------------------- 21 MERCANTILE BANK CORPORATION QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK -------------------------------------------------------------------------------- ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on our interest-earning assets over the interest paid on our interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness. Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality. We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to our net interest margin during periods of changing market interest rates. The following table depicts our GAP position as of September 30, 2001 (dollars in thousands): -------------------------------------------------------------------------------- (Continued) 22 MERCANTILE BANK CORPORATION QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK --------------------------------------------------------------------------------
Within Three to One to After Three Twelve Five Five Months Months Years Years Total ----------- ----------- ----------- ----------- ----------- Assets: Commercial loans $ 224,153 $ 4,824 $ 256,272 $ 8,807 $ 494,056 Residential real estate loans 12,168 1,021 17,214 8,867 39,270 Consumer loans 1,637 1,045 4,614 70 7,366 Investment securities (1) 1,287 1,108 27,635 41,265 71,295 Federal funds sold 5,100 5,100 Short term investments 157 157 Allowance for loan losses (7,930) (7,930) Other assets 37,319 37,319 ----------- ----------- ----------- ----------- ----------- Total assets 244,502 7,998 305,735 88,398 646,633 Liabilities: Interest-bearing checking 16,899 16,899 Savings 43,583 45,583 Money market accounts 5,068 5,068 Time deposits < $100,000 28,596 31,650 28,788 89,034 Time deposits $100,000 and over 99,064 123,977 101,219 324,260 Short-term borrowings 37,941 37,941 Long-term borrowings 205 16,000 16,205 Noninterest-bearing checking 39,892 39,892 Other liabilities 6,342 6,342 ----------- ----------- ----------- ----------- ----------- Total liabilities 231,356 155,627 130,007 62,234 579,224 Shareholders' equity 67,409 67,409 ----------- ----------- ----------- ----------- ----------- Total sources of funds 231,356 155,627 130,007 129,643 646,633 ----------- ----------- ----------- ----------- ----------- Net asset (liability) GAP $ 13,146 $ (147,629) $ 175,728 $ (41,245) =========== ============ =========== ============ Cumulative GAP $ 13,146 $ (134,483) $ 41,245 =========== ============ =========== Percent of cumulative GAP to total assets 2.0% (20.8)% 6.4% =========== =========== ===========
(1) Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of September 30, 2001. -------------------------------------------------------------------------------- (Continued) 23 MERCANTILE BANK CORPORATION QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK -------------------------------------------------------------------------------- The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors. We conducted multiple simulations as of September 30, 2001, whereby it was assumed that a simultaneous, instant and sustained change in market interest rates occurred. The following table reflects the suggested impact on net interest income over the next twelve months, which are well within our policy parameters established to manage and monitor interest rate risk.
Dollar Change In Percent Change In Interest Rate Scenario Net Interest Income Net Interest Income ---------------------- ------------------- ------------------- Interest rates down 200 basis points $ 3,060,000 17.5% Interest rates down 100 basis points 2,999,000 17.2 No change in interest rates 2,933,000 16.8 Interest rates up 100 basis points 3,048,000 17.4 Interest rates up 200 basis points 3,161,000 18.1
The increase in our net interest income under all interest rate scenarios reflects the expected repricing of local and out-of-area certificates of deposit during the next twelve months. Unlike interest rates on our floating rate loans that declined throughout the first nine months of 2001 as the prime rate declined, our certificates of deposit have fixed interest rates and only reprice at maturity. Throughout the remainder of 2001 and into 2002 we have a large volume of certificates of deposit that will mature and are expected to be refinanced at significantly lower interest rates. In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing and deposit gathering strategies; client preferences; and other factors. -------------------------------------------------------------------------------- 24 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time, we may be involved in various legal proceedings that are incidental to our business. In our opinion, we are not a party to any current legal proceedings that are material to our financial condition, either individually or in the aggregate. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. ITEM 5. OTHER INFORMATION. Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits:
EXHIBIT NO. EXHIBIT DESCRIPTION ----------- ------------------- 3.1 Articles of Incorporation are incorporated by reference to Exhibit 3.1 of our Registration Statement on Form SB-2 (Commission File no. 333-33081) that became effective on October 23, 1997 3.2 Our bylaws are incorporated by reference to Exhibit 3.2 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 11 Statement re Computation of Per Share Earnings
-------------------------------------------------------------------------------- (Continued) 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 9, 2001. MERCANTILE BANK CORPORATION By: /s/ Gerald R. Johnson, Jr. ------------------------------------------- Gerald R. Johnson, Jr. Chairman of the Board and Chief Executive Officer (Principal Executive Officer) By: /s/ Michael H. Price ------------------------------------------- Michael H. Price President and Chief Operating Officer By: /s/ Charles E. Christmas ------------------------------------------- Charles E. Christmas Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) -------------------------------------------------------------------------------- 26 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------ ----------- 3.1 Articles of Incorporation are incorporated by reference to exhibit 3.1 of our Registration Statement on Form SB-2 (Commission File no. 333-33081) that became effective on October 23, 1997 3.2 Our bylaws are incorporated by reference to exhibit 3.2 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 11 Statement re Computation of Per Share Earnings
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