10-Q 1 k80663e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 09/30/03 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, 2003 [ ] 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) (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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] At November 13, 2003, there were 6,804,912 shares of Common Stock outstanding. 1 MERCANTILE BANK CORPORATION INDEX
Page No. -------- PART 1. Financial Information Item I. Financial Statements Consolidated Balance Sheets - September 30, 2003 (Unaudited) and December 31, 2002................................. 3 Consolidated Statements of Income and Comprehensive Income - Three and Nine Months Ended September 30, 2003 (Unaudited) and September 30, 2002 (Unaudited)................................................... 4 Consolidated Statements of Changes in Shareholders' Equity - Nine Months Ended September 30, 2003 (Unaudited) and September 30, 2002 (Unaudited)................................................... 5 Consolidated Statements of Cash Flows - Three and Nine Months Ended September 30, 2003 (Unaudited) and September 30, 2002 (Unaudited)................................................... 6 Notes to Consolidated Financial Statements (Unaudited)................................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................. 16 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................... 25 Item 4. Controls and Procedures....................................................... 27 PART II. Other Information Item 1. Legal Proceedings............................................................. 28 Item 2. Changes in Securities and Use of Proceeds..................................... 28 Item 3. Defaults upon Senior Securities............................................... 28 Item 4. Submission of Matters to a Vote of Security Holders........................... 28 Item 5. Other Information............................................................. 28 Item 6. Exhibits and Reports on Form 8-K.............................................. 28 Signatures............................................................................. 30
2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS MERCANTILE BANK CORPORATION CONSOLIDATED BALANCE SHEETS
September 30, December 31, 2003 2002 ---- ---- (Unaudited) ASSETS Cash and due from banks $ 32,600,000 $ 23,404,000 Short-term investments 230,000 213,000 Federal funds sold 11,800,000 4,500,000 --------------- --------------- Total cash and cash equivalents 44,630,000 28,117,000 Securities available for sale 61,579,000 59,614,000 Securities held to maturity (fair value of $43,947,000 at September 30, 2003 and $37,985,000 at December 31, 2002) 42,444,000 36,493,000 Federal Home Loan Bank stock 3,927,000 786,000 Total loans and leases 972,191,000 771,554,000 Allowance for loan and lease losses (13,482,000) (10,890,000) --------------- --------------- Total loans and leases, net 958,709,000 760,664,000 Premises and equipment, net 15,229,000 12,174,000 Bank owned life insurance policies 16,013,000 14,876,000 Accrued interest receivable 4,142,000 3,336,000 Other assets 7,210,000 5,795,000 --------------- --------------- Total assets $ 1,153,883,000 $ 921,855,000 =============== =============== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest-bearing $ 77,448,000 $ 62,405,000 Interest-bearing 812,133,000 691,708,000 --------------- --------------- Total 889,581,000 754,113,000 Securities sold under agreements to repurchase 48,310,000 50,335,000 Federal Home Loan Bank advances 70,000,000 15,000,000 Other borrowed money 1,012,000 576,000 Accrued expenses and other liabilities 6,823,000 5,997,000 Trust preferred securities 16,000,000 16,000,000 --------------- --------------- Total liabilities 1,031,726,000 842,021,000 Shareholders' equity Preferred stock, no par value; 1,000,000 shares authorized, none issued Common stock, no par value: 9,000,000 shares authorized; 6,624,868 shares outstanding at September 30, 2003 and 5,405,706 shares outstanding at December 31, 2002 113,118,000 75,530,000 Retained earnings 8,951,000 3,250,000 Accumulated other comprehensive income 88,000 1,054,000 --------------- --------------- Total shareholders' equity 122,157,000 79,834,000 --------------- --------------- Total liabilities and shareholders' equity $ 1,153,883,000 $ 921,855,000 =============== ===============
See accompanying notes to consolidated financial statements. 3 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 30, September 30, September 30, September 30, 2003 2002 2003 2002 ---- ---- ---- ---- Interest income Loans, including fees $ 12,679,000 $ 11,132,000 $ 36,345,000 $ 31,553,000 Investment securities 1,164,000 1,144,000 3,566,000 3,344,000 Federal funds sold 11,000 41,000 50,000 98,000 Short-term investments 0 1,000 1,000 2,000 ------------- ------------- ------------- -------------- Total interest income 13,854,000 12,318,000 39,962,000 34,997,000 Interest expense Deposits 4,952,000 5,396,000 15,353,000 16,086,000 Short-term borrowings 168,000 242,000 512,000 668,000 Federal Home Loan Bank advances 274,000 0 531,000 0 Long-term borrowings 403,000 398,000 1,204,000 1,192,000 ------------- ------------- ------------- -------------- Total interest expense 5,797,000 6,036,000 17,600,000 17,946,000 ------------- ------------- ------------- -------------- NET INTEREST INCOME 8,057,000 6,282,000 22,362,000 17,051,000 Provision for loan and lease losses 1,380,000 880,000 2,850,000 2,022,000 ------------- ------------- ------------- -------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES 6,677,000 5,402,000 19,512,000 15,029,000 Noninterest income Service charges on accounts 303,000 243,000 852,000 660,000 Net gain on sales of securities 59,000 121,000 271,000 270,000 Other income 697,000 555,000 2,148,000 1,119,000 ------------- ------------- ------------- -------------- Total noninterest income 1,059,000 919,000 3,271,000 2,049,000 Noninterest expense Salaries and benefits 3,029,000 2,020,000 8,285,000 5,648,000 Occupancy 353,000 265,000 1,032,000 796,000 Furniture and equipment 272,000 183,000 738,000 545,000 Other expense 1,110,000 803,000 3,099,000 2,328,000 ------------- ------------- ------------- -------------- Total noninterest expenses 4,764,000 3,271,000 13,154,000 9,317,000 ------------- ------------- ------------- -------------- INCOME BEFORE FEDERAL INCOME TAX EXPENSE 2,972,000 3,050,000 9,629,000 7,761,000 Federal income tax expense 744,000 894,000 2,628,000 2,285,000 ------------- ------------- ------------- -------------- NET INCOME $ 2,228,000 $ 2,156,000 $ 7,001,000 $ 5,476,000 ============= ============= ============= ============== COMPREHENSIVE INCOME $ 1,611,000 $ 2,556,000 $ 6,035,000 $ 6,148,000 ============= ============= ============= ============== Basic earnings per share $ 0.40 $ 0.40 $ 1.28 $ 1.01 ============= ============= ============= ============== Diluted earnings per share $ 0.39 $ 0.39 $ 1.25 $ 1.00 ============= ============= ============= ============== Average basic shares outstanding 5,516,702 5,405,759 5,450,496 5,405,685 ============= ============= ============= ============== Average diluted shares outstanding 5,662,342 5,500,028 5,583,474 5,502,697 ============= ============= ============= ==============
See accompanying notes to consolidated financial statements. 4 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Accumulated Other Total Common Retained Comprehensive Shareholders' Stock Earnings Income Equity ----- -------- ------ ------- BALANCE, JANUARY 1, 2002 $ 69,406,000 $ 1,649,000 $ 408,000 $ 71,463,000 Comprehensive income: Net income for the period from January 1, 2002 through September 30, 2002 5,476,000 5,476,000 Change in net unrealized gain (loss) on securities available for sale, net of tax effect 672,000 672,000 ------------- Total comprehensive income 6,148,000 ------------- Stock option exercise, 578 shares 6,000 6,000 Issuance costs from December 2001 common stock sale (37,000) (37,000) ------------- ----------- ----------- ------------- BALANCE, SEPTEMBER 30, 2002 $ 69,375,000 $ 7,125,000 $ 1,080,000 $ 77,580,000 ============= =========== =========== ============= BALANCE, JANUARY 1, 2003 $ 75,530,000 $ 3,250,000 $ 1,054,000 $ 79,834,000 Comprehensive income: Net income for the period from January 1, 2003 through September 30, 2003 7,001,000 7,001,000 Change in net unrealized gain (loss) on securities available for sale, net of tax effect (966,000) (966,000) ------------- Total comprehensive income 6,035,000 ------------- Net proceeds from common stock sale, 1,195,310 shares 37,437,000 37,437,000 Common stock cash dividends (1,300,000) (1,300,000) Cash dividend reinvestment plan, 2,462 shares 77,000 77,000 Employee stock purchase plan, 1,367 shares 38,000 38,000 Stock option exercises, 20,023 shares 36,000 36,000 ------------- ----------- ----------- ------------- BALANCE, SEPTEMBER 30, 2003 $ 113,118,000 $ 8,951,000 $ 88,000 $ 122,157,000 ============= =========== =========== =============
See accompanying notes to 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, 2003 2002 2003 2002 ---- ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 2,228,000 $ 2,156,000 $ 7,001,000 $ 5,476,000 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 535,000 315,000 1,502,000 924,000 Provision for loan and lease losses 1,380,000 880,000 2,850,000 2,022,000 Net gain on sales of loans (16,000) 0 (16,000) 0 Net gain on sales of securities (59,000) (121,000) (271,000) (270,000) Net change in: Accrued interest receivable (681,000) (479,000) (806,000) (633,000) Bank owned life insurance policies (197,000) (116,000) (602,000) (208,000) Other assets (408,000) 102,000 (1,109,000) (892,000) Accrued expenses and other liabilities 705,000 1,095,000 826,000 583,000 ------------- ------------- ------------- ------------- Net cash from operating activities 3,487,000 3,832,000 9,375,000 7,002,000 CASH FLOWS FROM INVESTING ACTIVITIES Loans and leases originations and payments, net (106,222,000) (49,586,000) (200,879,000) (130,274,000) Purchases of: Securities available for sale (11,847,000) (9,510,000) (36,976,000) (28,481,000) Securities held to maturity (2,234,000) (1,392,000) (6,873,000) (6,173,000) Federal Home Loan Bank stock (1,677,000) 0 (3,141,000) (1,000) Proceeds from: Sales of available for sale securities 3,150,000 3,425,000 11,486,000 13,997,000 Maturities, calls and repayments of available for sale securities 7,061,000 4,653,000 21,888,000 12,557,000 Maturities, calls and repayments of held to maturity securities 381,000 0 915,000 1,005,000 Purchases of premises and equipment, net (1,366,000) (616,000) (3,914,000) (2,428,000) Purchases of bank owned life insurance policies (235,000) (10,475,000) (535,000) (10,475,000) ------------- ------------- ------------- ------------- Net cash from investing activities (112,989,000) (63,501,000) (218,029,000) (150,273,000) CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits 45,994,000 77,502,000 135,468,000 153,073,000 Net proceeds from the sale of common stock 37,437,000 0 37,437,000 (37,000) Stock option exercises 9,000 0 36,000 6,000 Employee stock purchase plan 14,000 0 38,000 0 Cash dividend reinvestment plan 63,000 0 77,000 0 Payment of cash dividends (434,000) 0 (1,300,000) 0 Net increase in Federal Home Loan Bank advances 25,000,000 0 55,000,000 0 Net increase (decrease) in other borrowed money 90,000 (1,247,000) 436,000 277,000 Net increase (decrease) in securities sold under agreements to repurchase 8,620,000 8,499,000 (2,025,000) 11,650,000 ------------- ------------- ------------- ------------- Net cash from financing activities 116,793,000 84,754,000 225,167,000 164,969,000 ------------- ------------- ------------- ------------- Net change in cash and cash equivalents 7,291,000 25,085,000 16,513,000 21,698,000 Cash and cash equivalents at beginning of period 37,339,000 16,551,000 28,117,000 19,938,000 ------------- ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 44,630,000 $ 41,636,000 $ 44,630,000 $ 41,636,000 ============= ============= ============= ============= Supplemental disclosures of cash flow information Cash paid during the year for Interest $ 5,742,000 $ 5,243,000 $ 17,466,000 $ 17,618,000 Federal income tax 1,150,000 850,000 3,725,000 2,805,000
See accompanying notes to consolidated financial statements. 6 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SIGNIFICANT ACCOUNTING POLICIES: Basis of Presentation: The unaudited financial statements for the three and nine months ended September 30, 2003 include the consolidated results of operations of Mercantile Bank Corporation and its consolidated subsidiaries. These subsidiaries include Mercantile Bank of West Michigan ("our bank"), our bank's three wholly-owned subsidiaries, Mercantile Bank Mortgage Company ("our mortgage company"), Mercantile BIDCO, Inc. ("our BIDCO") and Mercantile Insurance Center, Inc. ("our insurance center"), and our subsidiary MBWM Capital Trust I ("the trust"). 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 accounting principles generally accepted in the United States of America 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 periods ended September 30, 2003 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 our annual report on Form 10-K for the year ended December 31, 2002. Allowance for Loan and Lease Losses: The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and recoveries, and decreased by charge-offs. Management estimates the allowance balance required based on past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management's judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectability of a loan or lease balance is confirmed. A loan or lease is impaired when full payment under the loan or lease terms is not expected. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan or lease is impaired, a portion of the allowance is allocated so that the loan or lease is reported, net, at the present value of estimated future cash flows using the loan's or lease's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans and leases are evaluated for impairment when payments are delayed, typically 90 days or more, or when the internal grading system indicates a doubtful classification. Stock Compensation: Employee compensation expense under stock option plans is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation. (Continued) 7 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SIGNIFICANT ACCOUNTING POLICIES (Continued)
Quarter ended Nine months ended Sept 30, 2003 Sept 30, 2002 Sept 30, 2003 Sept 30, 2002 ------------- ------------- ------------- ------------- Net income as reported $ 2,228,000 $ 2,156,000 $ 7,001,000 $ 5,476,000 Deduct: Stock-based compensation expense determined under fair value based method 81,000 63,000 244,000 190,000 ------------- ------------- ------------- ------------- Pro forma net income 2,147,000 2,093,000 6,757,000 5,286,000 Basic earnings per share as reported $ 0.40 $ 0.40 $ 1.28 $ 1.01 Pro forma basic earnings per share 0.39 0.39 1.24 0.98 Diluted earnings per share as reported $ 0.39 $ 0.39 $ 1.25 $ 1.00 Pro forma diluted earnings per share 0.38 0.38 1.21 0.96
The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of grant date.
Quarter ended Nine months ended Sept 30, 2003 Sept 30, 2002 Sept 30, 2003 Sept 30, 2002 ------------- ------------- ------------- ------------- Risk-free interest rate 3.25% 5.25% 3.25% 5.25% Expected option life 7 Years 10 Years 7 Years 10 Years Expected stock price volatility 25% 42% 22% 32% Dividend yield 1.00% 0% 1.25% 0%
(Continued) 8 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 2. LOANS Our total loans and leases at September 30, 2003 were $972.2 million compared to $771.6 million at December 31, 2002, an increase of $200.6 million or 26.0%. The components of our outstanding balances at September 30, 2003 and December 31, 2002, and the percentage changes in loans and leases from the end of 2002 to the end of the third quarter 2003 are as follows:
Percent September 30, 2003 December 31, 2002 Increase/ Balance % Balance % (Decrease) ------- - ------- - ---------- Real Estate: Construction and land development $ 131,349,000 13.5% $ 103,900,000 13.5% 26.4% Secured by 1-4 family properties 81,096,000 8.3 60,828,000 7.9 33.3 Secured by multi-family properties 18,510,000 1.9 13,025,000 1.7 42.1 Secured by nonresidential properties 436,987,000 45.0 357,431,000 46.3 22.3 Commercial 298,063,000 30.7 230,662,000 29.9 29.2 Leases 1,049,000 0.1 850,000 0.1 23.4 Consumer 5,137,000 0.5 4,858,000 0.6 5.7 --------------- ----- --------------- ----- ----- Total loans and leases $ 972,191,000 100.0% $ 771,554,000 100.0% 26.0% =============== ===== =============== ===== ====
3. ALLOWANCE FOR LOAN AND LEASE LOSSES The following is a summary of the change in our allowance for loan and lease losses account for the three and nine months ended September 30:
Three months ended Nine months ended September 30, September 30, September 30, September 30, 2003 2002 2003 2002 ---- ---- ---- ---- Balance at beginning of period $ 12,158,000 $ 9,562,000 $ 10,890,000 $ 8,494,000 Charge-offs (95,000) (250,000) (524,000) (419,000) Recoveries 39,000 1,000 266,000 96,000 Provision for loan and lease losses 1,380,000 880,000 2,850,000 2,022,000 ------------- ------------- ------------- -------------- Balance at September 30 $ 13,482,000 $ 10,193,000 $ 13,482,000 $ 10,193,000 ============= ============= ============= ==============
(Continued) 9 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 4. PREMISES AND EQUIPMENT, NET Premises and equipment are comprised of the following:
September 30, December 31, 2003 2002 ---- ---- Land and improvements $ 5,736,000 $ 3,234,000 Buildings and leasehold improvements 7,888,000 7,009,000 Furniture and equipment 4,860,000 4,327,000 -------------- ------------- 18,484,000 14,570,000 Less accumulated depreciation 3,255,000 2,396,000 -------------- ------------- Premises and equipment, net $ 15,229,000 $ 12,174,000 ============== =============
Depreciation expense amounted to $308,000 during the third quarter of 2003, compared to $221,000 in the third quarter of 2002. Depreciation expense amounted to $859,000 during the first nine months of 2003, compared to $657,000 during the first nine months of 2002. 5. DEPOSITS Our total deposits at September 30, 2003 were $889.6 million compared to $754.1 million at December 31, 2002, an increase of $135.5 million, or 18.0%. The components of our outstanding balances at September 30, 2003 and December 31, 2002, and percentage change in deposits from the end of 2002 to the end of the third quarter 2003 are as follows:
Percent September 30, 2003 December 31, 2002 Increase/ Balance % Balance % (Decrease) ------- - ------- - ---------- Noninterest-bearing demand $ 77,448,000 8.7% $ 62,405,000 8.3% 24.1% Interest-bearing checking 28,468,000 3.2 28,130,000 3.7 1.2 Money market 9,179,000 1.0 8,592,000 1.1 6.8 Savings 94,537,000 10.7 69,461,000 9.2 36.1 Time, under $100,000 8,261,000 0.9 7,002,000 0.9 18.0 Time, $100,000 and over 87,389,000 9.8 66,005,000 8.8 32.4 ------------ ----- ------------ ----- ---- 305,282,000 34.3 241,595,000 32.0 26.4 Out-of-area time, under $100,000 101,647,000 11.4 85,557,000 11.4 18.8 Out-of-area time, $100,000 and over 482,652,000 54.3 426,961,000 56.6 13.0 ------------ ----- ------------ ----- ---- 584,299,000 65.7 512,518,000 68.0 14.0 ------------ ----- ------------ ----- ---- Total deposits $889,581,000 100.0% $754,113,000 100.0% 18.0% ============ ===== ============ ===== ====
(Continued) 10 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 6. BORROWINGS Information relating to our securities sold under agreements to repurchase follows:
September 30, December 31, 2003 2002 ---- ---- Outstanding balance at end of period $ 48,310,000 $ 50,335,000 Average interest rate at end of period 1.39% 1.54% Average balance during the period $ 43,563,000 $ 43,468,000 Average interest rate during the period 1.47% 2.03% Maximum month end balance during the period $ 48,310,000 $ 52,000,000
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. 7. FEDERAL HOME LOAN BANK ADVANCES Our outstanding balances at September 30, 2003 and December 31, 2002 were as follows.
September 30, December 31, 2003 2002 ---- ---- Maturities October 2003 through September, 2006, fixed rates from 1.53% to 3.21%, averaging 2.04% $70,000,000 0 Maturities September 2003 through December 2004, fixed rates from 1.69% to 2.39%, averaging 1.97% 0 $15,000,000 ----------- ----------- Total Federal Home Loan Bank advances $70,000,000 $15,000,000 =========== ===========
Each advance is payable at its maturity date, and is subject to a prepayment fee if paid prior to the maturity date. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of September 30, 2003 totaled $132.1 million, with availability approximating about $54.0 million. (Continued) 11 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 7. FEDERAL HOME LOAN BANK ADVANCES (Continued) Maturities of currently outstanding FHLB advances during the next five years are: 2003 $ 15,000,000 2004 25,000,000 2005 20,000,000 2006 10,000,000 2007 0
8. 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, 2003 and December 31, 2002 follows:
September 30, December 31, 2003 2002 ---- ---- Commercial unused lines of credit $ 169,963,000 $ 131,161,000 Unused lines of credit secured by 1-4 family residential properties 17,377,000 12,381,000 Credit card unused lines of credit 8,368,000 5,824,000 Other consumer unused lines of credit 4,528,000 4,415,000 Commitments to make loans 43,365,000 24,267,000 Standby letters of credit 43,771,000 39,338,000 -------------- --------------- Total loan and lease commitments $ 287,372,000 $ 217,386,000 ============== ===============
(Continued) 12 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 9. SALE OF COMMON STOCK On September 19, 2003, the Company sold 1,195,310 shares of common stock in a public offering, raising $37.4 million net of underwriting costs. Substantially all of the net proceeds were contributed to our bank as a capital injection. On October 17, 2003, the Company sold an additional 179,296 shares of common stock as the underwriters exercised their 30-day over-allotment option, raising an additional $5.6 million net of underwriting costs. Substantially all of the net proceeds were contributed to our bank as a capital injection. 10. 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 our financial statements. 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. (Continued) 13 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 10. REGULATORY MATTERS (Continued) Our actual capital levels and minimum required levels were (dollars in thousands):
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, 2003 Total capital (to risk weighted assets) Consolidated $ 151,550 13.9% $ 87,050 8.0% $ 108,812 10.0% Bank 148,055 13.6 86,838 8.0 108,547 10.0 Tier 1 capital (to risk weighted assets) Consolidated 138,068 12.7 43,525 4.0 65,287 6.0 Bank 134,573 12.4 43,419 4.0 65,129 6.0 Tier 1 capital (to average assets) Consolidated 138,068 12.8 43,333 4.0 54,164 5.0 Bank 134,573 12.5 43,253 4.0 54,066 5.0 December 31, 2002 Total capital (to risk weighted assets) Consolidated $ 105,671 12.1% $ 69,862 8.0% $ 87,328 10.0% Bank 102,810 11.8 69,728 8.0 87,160 10.0 Tier 1 capital (to risk weighted assets) Consolidated 94,781 10.9 34,931 4.0 52,397 6.0 Bank 91,920 10.6 34,864 4.0 52,296 6.0 Tier 1 capital (to average assets) Consolidated 94,781 10.7 35,355 4.0 44,193 5.0 Bank 91,920 10.4 35,313 4.0 44,142 5.0
Both the Company and our bank were categorized as well capitalized at September 30, 2003 and year-end 2002. (Continued) 14 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 10. REGULATORY MATTERS (Continued) 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. The Company's capital levels as of September 30, 2003 include an adjustment for the 1.6 million trust preferred securities issued by the trust subject to certain limitations. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in Tier 1 capital of the company to 25% of total Tier 1 capital. As of September 30, 2003, 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 6, 2003, that was paid on February 3, 2003, to record holders as of January 17, 2003. We have also paid three cash dividends on our common stock during 2003. On January 6, 2003, we declared a $0.08 per share cash dividend payable on March 10, 2003, to record holders as of February 10, 2003. On April 8, 2003, we declared a $0.08 per share cash dividend payable on June 10, 2003, to record holders as of May 12, 2003. On July 8, 2003, we declared a $0.08 per share cash dividend payable on September 10, 2003, to record holders as of August 11, 2003. On October 6, 2003, we declared a $0.08 per share cash dividend payable on December 10, 2003, to record holders as of November 10, 2003. 11. BENEFIT PLANS We sponsor an employee stock purchase plan which allows employees to defer after-tax payroll dollars and purchase our common stock on a quarterly basis. We have registered 26,250 shares of common stock to be issued and purchased under the plan. The plan allows for shares to be purchased directly from us or on the open market. During the nine months ended September 30, 2003, we issued the first 1,367 shares under the plan. 15 MERCANTILE BANK CORPORATION 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 consolidated subsidiaries, Mercantile Bank of West Michigan ("our bank"), our bank's three wholly-owned subsidiaries Mercantile Bank Mortgage Company ("our mortgage company"), Mercantile BIDCO, Inc. ("our BIDCO") and Mercantile Insurance Center, Inc. ("our insurance center"), and our subsidiary MBWM Capital Trust I ("the trust"), at September 30, 2003 to December 31, 2002 and the results of operations for the three and nine months ended September 30, 2003 and September 30, 2002. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to "us," "we," "our," or "the company" include Mercantile Bank Corporation and its consolidated subsidiaries referred to above. During the third quarter of 2003, we were engaged in preliminary discussions with one or more 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. 16 MERCANTILE BANK CORPORATION CRITICAL ACCOUNTING POLICIES Generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting and disclosure matters. Management must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. The Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a complete discussion of our significant accounting policies, see footnotes to our Consolidated Financial Statements included on pages F-28 through F-32 in our Form 10-K for the fiscal year ended December 31, 2002 (Commission file number 000-26719). Below is a discussion of our Allowance for Loan and Lease Losses policy. This policy is critical because it is highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. Management has reviewed the application of this policy with the Audit Committee of the Company's Board of Directors. Allowance for Loan and Lease Losses: The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and recoveries, and decreased by charge-offs. Management estimates the allowance balance required based on past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions. Allocations of the allowance may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management's judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectability of a loan or lease balance is confirmed. A loan or lease is impaired when full payment under the loan or lease terms is not expected. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan or lease is impaired, a portion of the allowance is allocated so that the loan or lease is reported, net, at the present value of estimated future cash flows using the loan's or lease's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans and leases are evaluated for impairment when payments are delayed, typically 90 days or more, or when the internal grading system indicates a doubtful classification. FINANCIAL CONDITION During the first nine months of 2003, our assets increased from $921.9 million on December 31, 2002, to $1,153.9 million on September 30, 2003. This represents a total increase in assets of $232.0 million, or 25.2%. The asset growth was comprised primarily of a $198.0 million increase in net loans, an increase of $16.5 million in cash and cash equivalents and an $11.1 million increase in securities. The increase in assets was primarily funded by a $135.5 million increase in deposits, an increase of $55.0 million in Federal Home Loan Bank advances and a $37.6 million increase in common stock. Commercial loans and leases increased by $180.1 million during the first nine months of 2003, and at September 30, 2003 totaled $886.0 million, or 91.1% of the total loan and lease portfolio. The continued significant concentration of the loan and lease portfolio in commercial loans and leases and the rapid growth of this portion of our lending 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 13 commercial lenders have an average commercial lending experience of approximately 15 years. Of each of the loan categories that we originate, we originate and manage commercial loans and leases most efficiently; thus reducing overhead costs 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. 17 MERCANTILE BANK CORPORATION Residential mortgage loans increased by $20.3 million and consumer loans increased by $0.3 million during the first nine months of 2003. As of September 30, 2003, residential mortgage and consumer loans totaled a combined $86.2 million, or 8.9% of the total loan and lease portfolio. Although we plan to increase our non-commercial loan portfolios in future periods, given our wholesale banking strategy, we expect the commercial sector of the lending efforts and resultant assets to remain the dominant loan portfolio category. Management believes the quality of our loan and lease portfolio remains strong. Net loan and lease charge-offs during the first nine months of 2003 totaled $258,000, or 0.04% of average total loans and leases on an annualized basis. Past due and nonaccrual loans and leases at September 30, 2003 totaled $287,000, or 0.03% of total loans and leases. We believe we have instilled a strong credit culture within our lending departments as it pertains to the underwriting and administration processes, which in part is reflected in our loan and lease charge-off and delinquency ratios. Over 98% 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 commercial banks outside the immediate area, which we underwrite using the same loan underwriting criteria as though our bank was the originating bank. Securities increased by $11.1 million, or 11.4%, during the first nine months of 2003. Purchases during the first nine months of 2003 totaled $47.0 million. Proceeds from the sales of securities totaled $11.5 million, while proceeds from the maturities, calls and repayments of securities totaled $22.8 million. Our securities portfolio consists of U.S. Government Agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government Agencies, investment-grade municipal securities and Federal Home Loan Bank of Indianapolis ("FHLBI") stock. Cash and cash equivalents increased $16.5 million, or 58.7%, during the first nine months of 2003, totaling $44.6 million on September 30, 2003. Cash and due from bank balances were up $9.2 million and federal funds sold increased $7.3 million. Our commercial lending and wholesale funding focus results in relatively large day-to-day fluctuations of our cash and cash equivalent balances. The average balance of cash and cash equivalents during the first nine months of 2003 equaled $28.8 million, or approximately 35% below the balance at September 30, 2003. On April 30, 2003, our bank purchased an existing building situated on 2.75 acres of land located about two miles north of the center of downtown Grand Rapids for approximately $1.3 million. We plan to demolish the existing building and design and construct a four-story facility on this property. This facility will serve as the new location for our current downtown facility, which includes a vast majority of our commercial lending function, and will house the administration and loan operations functions currently housed at other of our locations. Expected completion date of the new facility is during the latter part of 2005. On September 29, 2003, our bank purchased ten acres of land located in Holland, Michigan for approximately $0.9 million. Subject to regulatory approvals, we plan to design and construct a two-story facility on this property. This facility will serve as the new location for our current loan production office which currently operates out of a leased facility, and will also house a full-service branch and part of our commercial lending function. Expected completion date of the new facility is during the latter part of 2004. 18 MERCANTILE BANK CORPORATION Deposits increased $135.5 million during the first nine months of 2003, totaling $889.6 million at September 30, 2003. Local deposits increased $63.7 million, or 26.4%, while out-of-area deposits increased $71.8 million, or 14.0%. As a percent of total deposits, local deposits increased from 32.0% on December 31, 2002, to 34.3% on September 30, 2003. Noninterest-bearing demand deposits, comprising 8.7% of total deposits, increased $15.0 million during the first nine months of 2003. Savings deposits (10.7% of total deposits) increased $25.1 million, money market deposit accounts (1.0% of total deposits) increased $0.6 million and interest-bearing checking deposits (3.2% of total deposits) increased $0.3 million during the first nine months of 2003. Local certificates of deposit, comprising 10.7% of total deposits, increased by $22.6 million during the first nine months of 2003. Out-of-area deposits increased $71.8 million during the first nine months of 2003, totaling $584.3 million, or 65.7% of total deposits, as of September 30, 2003. Out-of-area deposits consist primarily of certificates of deposit obtained from depositors located outside our 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 2003 rates paid on new out-of-area certificates of deposit were generally lower than 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. 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, our relatively high reliance on out-of-area deposits will likely continue. Securities sold under agreements to repurchase ("repurchase agreements") decreased by $2.0 million during the first nine months of 2003, totaling $48.3 million as of September 30, 2003. 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. FHLBI advances increased by $55.0 million during the first nine months of 2003, totaling $70.0 million as of September 30, 2003. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. The amount available under our borrowing line of credit totaled approximately $54.0 million as of September 30, 2003. FHLBI advances, along with out-of-area deposits, are the primary components of our wholesale funding program. Common stock increased by $37.6 million during the first nine months of 2003, totaling $113.1 million as of September 30, 2003. A vast majority of the increase was due to the sale of common stock through a public offering completed in September, whereby we sold 1,195,310 shares at a price of $33.26 per share. Net proceeds from the sale, after deducting for underwriting expenses, approximated $37.4 million. LIQUIDITY Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and 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 advances from the FHLBI, as well as liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. 19 MERCANTILE BANK CORPORATION 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, this growth has not been sufficient to meet our substantial loan growth and provide monies for additional investing activities. To assist in providing the additional needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, comprised of certificates of deposit from customers outside our market area, and since the fourth quarter of 2002, advances from the FHLBI, totaled $654.3 million, or 64.9%, of combined deposits and borrowed funds. As of December 31, 2002, wholesale funds totaled $527.5 million, or 64.3%, of combined deposits and borrowed funds. Reliance on wholesale funds is expected to continue due to our anticipated future asset growth. Our bank has the ability to borrow money on a daily basis through correspondent banks via established unsecured federal funds purchased lines, totaling $35.0 million as of September 30, 2003. The average balance of federal funds purchased during the first nine months of 2003 equaled $3.3 million, compared to a $5.8 million average federal funds sold position. As a member of the FHLBI, our bank has access to the FHLBI's borrowing programs. As of September 30, 2003, advances from the FHLBI totaled $70.0 million, up from the $15.0 million outstanding at December 31, 2002. Based on available collateral at September 30, 2003, our bank could borrow up to approximately $54.0 million. In addition to typical 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, 2003, our bank had a total of $243.6 million in unfunded loan commitments and $43.8 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $200.2 million were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and $43.4 million were for loan commitments expected to close and become funded within the next three to six 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 increased by $42.4 million during the first nine months of 2003, from $79.8 million on December 31, 2002, to $122.2 million at September 30, 2003. The increase is primarily attributable to the sale of common stock and net income. During September we sold 1,195,310 shares of common stock in a public offering, raising $37.4 million net of underwriting costs. Substantially all of the net proceeds were contributed to our bank as a capital injection. Net income of $7.0 million was recorded during the first nine months of 2003. Shareholders' equity was negatively impacted during the first nine months of 2003 by the payment of cash dividends totaling $1.3 million and a $1.0 million mark-to-market adjustment for available for sale securities as defined in SFAS No. 115. On October 17, 2003, the Company sold an additional 179,296 shares of common stock as the underwriters exercised their 30-day over-allotment option, raising an additional $5.6 million net of underwriting costs. Substantially all of the net proceeds were contributed to our bank as a capital injection. 20 MERCANTILE BANK CORPORATION In September 1999 we, through the trust, issued 1.6 million shares of trust preferred securities at $10.00 per trust preferred security. 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, 2003, the entire $16.0 million of trust preferred securities were included as Tier 1 capital. We are subject to regulatory capital requirements primarily administered by federal bank regulatory 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, 2003 and December 31, 2002 are disclosed under Note 10 of the Notes to Consolidated Financial Statements. 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 6, 2003, which was paid on February 3, 2003 to record holders as of January 17, 2003. We have also paid three cash dividends on our common stock during 2003. We paid a $0.08 per share cash dividend on March 10, 2003, June 10, 2003 and on September 10, 2003. On October 6, 2003, we declared a $0.08 per share cash dividend payable on December 10, 2003, to record holders as of November 10, 2003. RESULTS OF OPERATIONS Net income for the third quarter of 2003 was $2.23 million ($0.40 per basic share and $0.39 per diluted share), which represents a 3.3% increase over net income of $2.16 million ($0.40 per basic share and $0.39 per diluted share) recorded during the third quarter of 2002. Net income for the first nine months of 2003 was $7.0 million ($1.28 per basic share and $1.25 per diluted share), which represents a 27.8% increase over net income of $5.5 million ($1.01 per basic share and $1.00 per diluted share) recorded during the first nine months of 2002. During both time periods net income was positively impacted by an increase in net interest income, higher noninterest income and greater employee efficiency. Higher provision expense driven by significantly higher loan growth negatively impacted net income, especially during the third quarter of 2003. Interest income during the third quarter of 2003 was $13.9 million, an increase of 12.5% over the $12.3 million earned during the third quarter of 2002. Interest income during the first nine months of 2003 was $40.0 million, an increase of 14.2% over the $35.0 million earned during the first nine months of 2002. The growth in interest income during both time periods is primarily attributable to an increase in earning assets, which more than offset the negative impact of a declining interest rate environment. During the third quarter of 2003 earning assets averaged $1,029.2 million, $246.8 million higher than the average earning assets of $782.4 million during the third quarter of 2002. Average loans were up $230.4 million and securities increased $21.3 million, while federal funds sold were down $5.2 million. During the first nine months of 2003 earning assets averaged $959.1 million, $223.2 million higher than the average earning assets of $735.9 million during the same time period in 2002. Average loans were up $202.3 million and securities increased $22.6 million, while federal funds sold were down $1.8 million. During the third quarter of 2003 and 2002, earning assets had a weighted average yield (tax equivalent-adjusted basis) of 5.49% and 6.33%, respectively. During the first nine months of 2003 and 2002 earning assets had a weighted average yield of 5.38% and 6.17%, respectively. The decrease in weighted average yields is primarily due to the decline in market interest rates. 21 MERCANTILE BANK CORPORATION Interest expense during the third quarter of 2003 was $5.8 million, a decrease of 4.0% from the $6.0 million expensed during the third quarter of 2002. Interest expense during the first nine months of 2003 was $17.6 million, a decrease of 1.9% from the $17.9 million expensed during the first nine months of 2002. The decrease in interest expense is primarily attributable to the overall decline of market interest rates, which more than offset the increase in funding liabilities necessitated by the growth in assets. During the third quarter of 2003, interest-bearing liabilities averaged $921.8 million, $234.0 million higher than average interest-bearing liabilities of $687.8 million during the third quarter of 2002. Average interest-bearing deposits were up $174.2 million and FHLBI advances increased $56.5 million. During the first nine months of 2003 interest-bearing liabilities averaged $858.3 million, $213.8 million higher than average interest-bearing funds of $644.5 million during the same time period in 2002. Average interest-bearing deposits were up $170.5 million and FHLBI advances increased $37.5 million. During the third quarter of 2003 and 2002, interest-bearing liabilities had a weighted average rate of 2.50% and 3.48%, respectively. During the first nine months of 2003 and 2002 interest-bearing liabilities had a weighted average rate of 2.74% and 3.72%, respectively. The decrease in the weighted average cost of interest-bearing liabilities in 2003 is primarily due to the decline in market interest rates. Net interest income during the third quarter of 2003 was $8.1 million, an increase of 28.3% over the $6.3 million earned during the third quarter of 2002. Net interest income during the first nine months of 2003 was $22.4 million, an increase of 31.1% over the $17.1 million earned during the same time period in 2002. The increase in net interest income was due to growth in earning assets. The net interest margin declined from 3.27% during the third quarter of 2002 to 3.19% in third quarter of 2003, but increased from 3.18% during the first nine months of 2002 to 3.20% in the first nine months of 2003. The following table sets forth certain information relating to 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 2003 and 2002. 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. Tax-exempt securities interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 34%. Securities interest income was increased by $207,000 and $159,000 in the third quarter of 2003 and 2002, respectively, for this adjustment. 22 MERCANTILE BANK CORPORATION
Quarters ended September 30, ----------------------------------------------------------------------------------- 2 0 0 3 2 0 0 2 --------------------------------------- --------------------------------------- Average Average Average Average Balance Interest Rate Balance Interest Rate ------- -------- ---- ------- -------- ---- (dollars in thousands) ASSETS Loans $ 918,966 $ 12,679 5.47% $ 688,550 $ 11,132 6.41% Investment securities 105,485 1,371 5.20 84,163 1,303 6.19 Federal funds sold 4,309 11 0.97 9,527 41 1.68 Short term investments 444 0 0.50 195 1 1.25 ----------- ----------- ----------- ----------- Total interest-earning assets 1,029,204 14,061 5.49 782,435 12,477 6.33 Allowance for loan and lease losses (12,842) (9,927) Other assets 66,464 48,641 ----------- ----------- Total assets $ 1,082,826 $ 821,149 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits $ 798,947 4,952 2.46 $ 624,792 5,396 3.43% Short-term borrowings 49,437 168 1.35 46,540 242 2.06 FHLB advances 56,467 274 1.90 0 0 NA Long-term borrowings 16,958 403 9.51 16,485 398 9.66 ----------- ----------- ----------- ----------- Total interest-bearing liabilities 921,809 5,797 2.50 687,817 6,036 3.48 Noninterest-bearing deposits 68,344 51,869 Other liabilities 6,163 5,113 Shareholders' equity 86,510 76,350 ----------- ----------- ---- ----------- ----------- ---- Total liability and shareholders' equity $ 1,082,826 $ 821,149 =========== =========== Net interest income $ 8,264 $ 6,441 =========== =========== Net interest rate spread 2.99% 2.85% ==== ==== Net interest rate spread on average assets 3.02% 3.11% ==== ==== Net interest margin on earning assets 3.19% 3.27% ==== ====
Provisions to the allowance for loan and lease losses during the third quarter of 2003 were $1.4 million, compared to the $0.9 million expensed during the third quarter of 2002. Provisions to the allowance for loan and lease losses during the first nine months of 2003 were $2.9 million, compared to the $2.0 million that was expensed during the same time period in 2002. The increase during both time periods primarily reflects the higher volume of loan growth. Net loan charge-offs during the third quarter of 2003 were $56,000 compared to net loan charge-offs of $249,000 during the third quarter of 2002. During the first nine months of 2003 net loan charge-offs totaled $258,000 compared to net loan charge-offs of $323,000 during the same time period in 2002. The allowance for loan and lease losses as a percentage of total loans outstanding as of September 30, 2003 was 1.39%, compared to 1.41% at December 31, 2002. In each accounting period, the allowance for loan and lease losses is adjusted to the amount believed necessary to maintain the allowance for loan and lease losses at adequate levels. Through the loan review and credit departments, we attempt to allocate specific portions of the allowance for loan and lease losses based on specifically identifiable problem loans and leases. The evaluation of the allowance for loan and lease losses is further based on, although not limited to, consideration of the internally prepared Loan Loss Reserve Analysis ("Reserve Analysis"), composition of the loan and lease portfolio, third party analysis of the loan administration processes and loan portfolio and general economic conditions. In addition, the rapid growth of the loan and lease portfolio is taken into account. 23 MERCANTILE BANK CORPORATION 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 and leases, which continue to comprise a vast majority of our loan and lease portfolio, 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 2003 was $1.1 million, an increase of 15.2% over the $0.9 million earned during the third quarter of 2002. Noninterest income during the first nine months of 2003 was $3.3 million, an increase of 59.6% over the $2.0 million earned during the same time period in 2002. Service charge income on deposits and repurchase agreements increased $60,000 (24.7%) during the third quarter of 2003 over that earned in the third quarter of 2002, and during the first nine months of 2003 increased $192,000 (29.1%) over that earned in the comparable time period in 2002. The increases during both time periods primarily results from new accounts opened during the last twelve months, decline in the earnings credit rate and adjustments in our deposit fee structure. Primarily reflecting the low and declining interest rate environment and resulting increase in residential mortgage loan refinancings, fees earned on referring residential mortgage loan applicants to third parties and selling residential mortgage loans to third parties increased from $147,000 earned during the third quarter of 2002 to $275,000 recorded during the third quarter of 2003, and increased from $318,000 earned during the first nine months of 2002 to $851,000 recorded during the first nine months of 2003. Noninterest income related to an increase in the cash surrender value of bank owned life insurance policies ("BOLI") totaled $197,000 during the third quarter of 2003 compared to $116,000 earned during the third quarter of 2002, and totaled $602,000 during the first nine months of 2003 compared to $208,000 earned during the first nine months of 2002. The growth in income related to BOLI primarily results from additional BOLI policies purchased during the past twelve months. Gains recognized on the sales of securities totaled $59,000 during the third quarter of 2003, resulting from the sale of four mortgage-backed securities with an aggregate book value of $3.1 million. The sales were transacted as part of our interest rate risk management program. The sales proceeds were used to purchase mortgage-backed securities with different underlying interest rate risk characteristics than those contained in the securities that were sold. Noninterest expense during the third quarter of 2003 was $4.8 million, an increase of 45.6% over the $3.3 million expensed during the same time period in 2002. Noninterest expense during the first nine months of 2003 was $13.2 million, an increase of 41.2% over the $9.3 million expensed during the same time period in 2002. Employee salary and benefit expenses were $1.0 million higher during the third quarter of 2003 than the level expensed during the third quarter of 2002, and were $2.6 million higher during the first nine months of 2003 than the level expensed during the first nine months of 2002. The increases during both time periods primarily resulted from the hiring of additional staff and merit annual pay increases. The level of full-time equivalent employees increased from 113 at September 30, 2002 to 156 as of September 30, 2003. Occupancy and furniture and equipment costs increased $177,000 in the third quarter of 2003 over the level expensed in the third quarter of 2002, and increased $429,000 during the first nine months of 2003 over the level expensed during the first nine months of 2002 primarily reflecting the opening of two new branch facilities and a loan production office during the past ten months. General overhead costs also increased, reflecting the additional expenses required to administer our significantly increased asset base. 24 MERCANTILE BANK CORPORATION Monitoring and controlling noninterest costs, while at the same time providing high quality service to customers, is a key component to our business strategy. While the dollar volume of noninterest costs has increased, the rate of growth has been lower than the rate of increase in net interest income and noninterest income. Noninterest expenses increased by $1.5 million during the third quarter of 2003 over the amount expensed during the third quarter of 2002, and increased by $3.8 million during the first nine months of 2003 over the amount expensed during the first nine months of 2002. However, net revenues (net interest income plus noninterest income) increased at a higher level of $1.9 million and $6.5 million during the same time periods, respectively. Federal income tax expense was $0.7 million and $0.9 million during the third quarter of 2003 and 2002, respectively. Although net income before tax was similar during both time periods, federal income tax expense was lower during the third quarter of 2003 primarily due to a reduction in our effective tax rate. Federal income tax expense was $2.6 million and $2.3 million during the first nine months of 2003 and 2002, respectively. The increase was primarily due to an increase in net income before federal income tax expense, which more than offset a decline in our effective tax rate. 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, 2003 (dollars in thousands): 25 MERCANTILE BANK CORPORATION
Within Three to One to After Three Twelve Five Five Months Months Years Years Total ------ ------ ----- ----- ----- Assets: Commercial loans and leases (1) $ 386,634 $ 27,272 $ 424,252 $ 47,800 $ 885,958 Residential real estate loans 41,829 2,668 27,410 9,189 81,096 Consumer loans 1,164 641 3,262 70 5,137 Investment securities (2) 3,933 5,059 29,453 69,505 107,950 Federal funds sold 11,800 11,800 Short-term investments 230 230 Allowance for loan and lease losses (13,482) (13,482) Other assets 75,194 75,194 ----------- ----------- ----------- ----------- ----------- Total assets 445,590 35,640 484,377 188,276 1,153,883 Liabilities: Interest-bearing checking 28,468 28,468 Savings 94,537 94,537 Money market accounts 9,179 9,179 Time deposits < $100,000 22,299 54,958 32,651 109,908 Time deposits $100,000 and over 124,246 302,902 142,893 570,041 Short-term borrowings 48,310 48,310 FHLB advances 15,000 20,000 35,000 70,000 Long-term borrowings 1,012 16,000 17,012 Noninterest-bearing checking 77,448 77,448 Other liabilities 6,823 6,823 ----------- ----------- ----------- ----------- ----------- Total liabilities 343,051 377,860 210,544 100,271 1,031,726 Shareholders' equity 122,157 122,157 ----------- ----------- ----------- ----------- ----------- Total sources of funds 343,051 377,860 210,544 222,428 1,153,883 ----------- ----------- ----------- ----------- ----------- Net asset (liability) GAP $ 102,539 $ (342,220) $ 273,833 $ (34,152) =========== =========== =========== =========== Cumulative GAP $ 102,539 $ (239,681) $ 34,152 =========== =========== =========== Percent of cumulative GAP to total assets 8.9% (20.7)% 3.0% =========== =========== ===========
(1) Floating rate loans that are currently at interest rate floors are treated as fixed rate loans and are reflected using maturity date and not repricing frequency. (2) Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of September 30, 2003. 26 MERCANTILE BANK CORPORATION The second interest rate risk measurement we use 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, 2003, whereby it was assumed that a simultaneous, instant and sustained change in market interest rates occurred. The following table reflects the suggested impact on our 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 $ (504,000) (1.5)% Interest rates down 100 basis points 316,000 1.0 No change in interest rates 841,000 2.6 Interest rates up 100 basis points 1,657,000 5.1 Interest rates up 200 basis points 2,482,000 7.6
The increase in our net interest income under all interest rate scenarios except the down 200 basis points scenario 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 since the beginning of 2001 as market interest rates began to decline, our certificates of deposit have fixed interest rates and only reprice at maturity. Throughout the remainder of 2003 and into 2004 we have a large volume of certificates of deposit that will mature and are expected to be refinanced at 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. ITEM 4. CONTROLS AND PROCEDURES As of September 30, 2003, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of September 30, 2003. 27 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 On February 10, 2003 we issued 7,500 shares of our common stock to two of our executive officers upon their exercise of employee stock options issued under our 1997 Employee Stock Option Plan. We received a weighted average exercise price of $8.782 per share aggregating $65,865 for these shares. These shares were substantially paid by the executive officers delivering to us common stock of the company that they already owned having an aggregate value of $62,987, with the difference paid in cash. On August 11, 2003 we issued 6,000 shares of our common stock to two of our executive officers upon their exercise of employee stock options issued under our 1997 Employee Stock Option Plan. We received a weighted average exercise price of $8.638 per share aggregating $51,828 for these shares. These shares were paid by the executive officers delivering to us common stock of the company that they already owned having an aggregate value of $43,167, with the difference paid in cash. These shares were issued in reliance on an exemption from registration under the Securities Act of 1933 based on Section 4(2) of that Act, and Regulation D issued under that Act. 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 Amended and Restated Bylaws dated as of January 16, 2003 are incorporated by reference to Exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003 11 Statement re Computation of Per Share Earnings 31 Rule 13a-14(a) Certifications 32.1 Section 1350 Chief Executive Officer Certification 32.2 Section 1350 Chief Financial Officer Certification 28 (b) Reports of Form 8-K During the third quarter of 2003, the Company furnished the following report on Form 8-K: i) Dated July 9, 2003, pertaining to the Company's press release issued on July 9, 2003 reporting financial results and earnings for its second quarter of 2003 29 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 13, 2003. 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/ Charles E. Christmas ------------------------------------------------ Charles E. Christmas Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) 30 EXHIBIT INDEX 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 Amended and Restated Bylaws dated as of January 16, 2003 are incorporated by reference to Exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003 11 Statement re Computation of Per Share Earnings 31 Rule 13a-14(a) Certifications 32.1 Section 1350 Chief Executive Officer Certification 32.2 Section 1350 Chief Financial Officer Certification