10-Q 1 k86649e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 06/30/04 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 June 30, 2004 [ ] 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, MI 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 August 6, 2004, there were 7,175,930 shares of Common Stock outstanding. 1 MERCANTILE BANK CORPORATION INDEX
Page No. -------- PART I. Financial Information Item 1. Financial Statements Consolidated Balance Sheets - June 30, 2004 (Unaudited) and December 31, 2003..................................... 3 Consolidated Statements of Income and Comprehensive Income - Three and Six Months Ended June 30, 2004 (Unaudited) and June 30, 2003 (Unaudited)........................................................... 4 Consolidated Statements of Changes in Shareholders' Equity - Six Months Ended June 30, 2004 (Unaudited) and June 30, 2003 (Unaudited)........................................................... 5 Consolidated Statements of Cash Flows - Three and Six Months Ended June 30, 2004 (Unaudited) and June 30, 2003 (Unaudited)........................................................... 6 Notes to Consolidated Financial Statements (Unaudited)................................. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................. 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................... 24 Item 4. Controls and Procedures....................................................... 26 PART II. Other Information Item 1. Legal Proceedings............................................................. 27 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.................................................................. 27 Item 3. Defaults upon Senior Securities............................................... 27 Item 4. Submission of Matters to a Vote of Security Holders........................... 27 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
June 30, December 31, 2004 2003 ---- ---- (Unaudited) ASSETS Cash and due from banks $ 35,005,000 $ 16,309,000 Short-term investments 967,000 255,000 --------------- ---------------- Total cash and cash equivalents 35,972,000 16,564,000 Securities available for sale 69,751,000 71,421,000 Securities held to maturity (fair value of $48,921,000 at June 30, 2004 and $47,102,000 at December 31, 2003) 48,466,000 45,112,000 Federal Home Loan Bank stock 6,644,000 4,977,000 Total loans and leases 1,185,363,000 1,035,963,000 Allowance for loan and lease losses (16,312,000) (14,379,000) ---------------- ----------------- Total loans and leases, net 1,169,051,000 1,021,584,000 Premises and equipment, net 18,468,000 15,305,000 Bank owned life insurance policies 16,796,000 16,441,000 Accrued interest receivable 4,257,000 4,098,000 Other assets 9,221,000 7,835,000 --------------- ---------------- Total assets $ 1,378,626,000 $ 1,203,337,000 =============== ================ LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest-bearing $ 114,441,000 $ 76,579,000 Interest-bearing 931,628,000 826,313,000 --------------- ---------------- Total deposits 1,046,069,000 902,892,000 Securities sold under agreements to repurchase 46,960,000 49,545,000 Federal funds purchased 7,000,000 6,000,000 Federal Home Loan Bank advances 120,000,000 90,000,000 Subordinated debentures 16,495,000 16,495,000 Other borrowed money 1,414,000 1,114,000 Accrued expenses and other liabilities 6,416,000 7,090,000 --------------- ---------------- Total liabilities 1,244,354,000 1,073,136,000 Shareholders' equity Preferred stock, no par value; 1,000,000 shares authorized, none issued 0 0 Common stock, no par value: 9,000,000 shares authorized; 7,175,896 shares outstanding at June 30, 2004 and 6,805,914 shares outstanding at December 31, 2003 130,902,000 118,560,000 Retained earnings 4,166,000 11,421,000 Accumulated other comprehensive income (loss) (796,000) 220,000 ---------------- ---------------- Total shareholders' equity 134,272,000 130,201,000 --------------- ---------------- Total liabilities and shareholders' equity $ 1,378,626,000 $ 1,203,337,000 =============== ================
See accompanying notes to consolidated financial statements. 3 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
Three Months Three Months Six Months Six Months Ended Ended Ended Ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- (Unaudited) (Unaudited) (Unaudited) (Unaudited) Interest income Loans and leases, including fees $ 14,722,000 $ 12,223,000 $ 28,630,000 $ 23,666,000 Investment securities 1,400,000 1,186,000 2,826,000 2,402,000 Federal funds sold 8,000 23,000 27,000 39,000 Short-term investments 0 1,000 1,000 1,000 --------------- ------------- ------------- ------------- Total interest income 16,130,000 13,433,000 31,484,000 26,108,000 Interest expense Deposits 4,929,000 5,165,000 9,679,000 10,401,000 Short-term borrowings 186,000 173,000 356,000 344,000 Federal Home Loan Bank advances 597,000 183,000 1,126,000 257,000 Long-term borrowings 418,000 413,000 834,000 825,000 --------------- ------------- ------------- ------------- Total interest expense 6,130,000 5,934,000 11,995,000 11,827,000 --------------- ------------- ------------- ------------- NET INTEREST INCOME 10,000,000 7,499,000 19,489,000 14,281,000 Provision for loan and lease losses 1,230,000 845,000 2,474,000 1,470,000 --------------- ------------- ------------- ------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES 8,770,000 6,654,000 17,015,000 12,811,000 Noninterest income Services charges on accounts 312,000 280,000 611,000 549,000 Net gain on sales of securities 0 212,000 78,000 212,000 Net gain on sales of loans 40,000 0 40,000 0 Other income 649,000 755,000 1,311,000 1,475,000 --------------- ------------- ------------- ------------- Total noninterest income 1,001,000 1,247,000 2,040,000 2,236,000 Noninterest expense Salaries and benefits 3,510,000 2,759,000 6,793,000 5,256,000 Occupancy 383,000 345,000 769,000 679,000 Furniture and equipment 267,000 245,000 540,000 466,000 Other expense 1,240,000 1,012,000 2,453,000 1,989,000 --------------- ------------- ------------- ------------- Total noninterest expenses 5,400,000 4,361,000 10,555,000 8,390,000 --------------- ------------- ------------- ------------- INCOME BEFORE FEDERAL INCOME TAX EXPENSE 4,371,000 3,540,000 8,500,000 6,657,000 Federal income tax expense 1,225,000 1,000,000 2,381,000 1,884,000 --------------- ------------- ------------- ------------- NET INCOME $ 3,146,000 $ 2,540,000 $ 6,119,000 $ 4,773,000 =============== ============= ============= ============= COMPREHENSIVE INCOME $ 1,740,000 $ 2,325,000 $ 5,103,000 $ 4,424,000 =============== ============= ============= ============= Basic earnings per share $ 0.44 $ 0.45 $ 0.85 $ 0.84 =============== ============= ============= ============= Diluted earnings per share $ 0.43 $ 0.44 $ 0.84 $ 0.82 =============== ============= ============= ============= Cash dividends per share $ 0.09 $ 0.08 $ 0.18 $ 0.16 =============== ============= ============= ============= Average basic shares outstanding 7,172,633 5,692,176 7,165,744 5,687,686 =============== ============= ============= ============= Average diluted shares outstanding 7,322,474 5,823,186 7,310,298 5,817,740 =============== ============= ============= =============
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, 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 June 30, 2003 4,773,000 4,773,000 Change in net unrealized gain (loss) on securities available for sale, net of reclassifications and tax effect (349,000) (349,000) ------------- Total comprehensive income 4,424,000 Common stock cash dividends, $0.16 per share (866,000) (866,000) Cash dividend reinvestment plan, 567 shares 14,000 14,000 Employee stock purchase plan, 935 shares 24,000 24,000 Stock option exercises, 15,436 shares 27,000 27,000 ------------- ------------- ------------- ------------- BALANCE, JUNE 30, 2003 $ 75,595,000 $ 7,157,000 $ 705,000 $ 83,457,000 ============= ============= ============= ============= BALANCE, JANUARY 1, 2004 $ 118,560,000 $ 11,421,000 $ 220,000 $ 130,201,000 Comprehensive income: Net income for the period from January 1, 2004 through June 30, 2004 6,119,000 6,119,000 Change in net unrealized gain (loss) on securities available for sale, net of reclassifications and tax effect (1,016,000) (1,016,000) ------------- Total comprehensive income 5,103,000 Payment of 5% stock dividend, 340,180 shares 12,112,000 (12,116,000) (4,000) Common stock cash dividends, $0.18 per share (1,258,000) (1,258,000) Cash dividend reinvestment plan, 1,909 shares 65,000 65,000 . Employee stock purchase plan, 1,094 shares 38,000 38,000 Stock option exercises, 26,799 shares 127,000 127,000 ------------- ------------- ------------- ------------- BALANCE, JUNE 30, 2004 $ 130,902,000 $ 4,166,000 $ (796,000) $ 134,272,000 ============= ============= ============= =============
See accompanying notes to consolidated financial statements. 5 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months Three Months Six Months Six Months Ended Ended Ended Ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- (Unaudited) (Unaudited) (Unaudited) (Unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 3,146,000 $ 2,540,000 $ 6,119,000 $ 4,773,000 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 436,000 516,000 848,000 967,000 Provision for loan and lease losses 1,230,000 845,000 2,474,000 1,470,000 Net gain on sales of loans (40,000) 0 (40,000) 0 Net gain on sales of securities 0 (212,000) (78,000) (212,000) Net change in: Accrued interest receivable 567,000 399,000 (159,000) (125,000) Bank owned life insurance policies (178,000) (197,000) (355,000) (405,000) Other assets (1,429,000) (1,217,000) (998,000) (701,000) Accrued expenses and other liabilities 359,000 35,000 (674,000) 121,000 ------------- ------------- ------------- ------------- Net cash used in operating activities 4,091,000 2,709,000 7,137,000 5,888,000 CASH FLOWS FROM INVESTING ACTIVITIES Loan and leases originations and payments, net (74,426,000) (53,615,000) (149,901,000) (94,657,000) Purchases of: Securities available for sale (9,970,000) (16,380,000) (12,964,000) (25,129,000) Securities held to maturity (2,910,000) (1,958,000) (4,336,000) (4,639,000) Federal Home Loan Bank stock (860,000) (1,464,000) (1,667,000) (1,464,000) Proceeds from: Maturities, calls and repayments of available for sale securities 3,016,000 8,253,000 11,340,000 14,827,000 Maturities, calls and repayments of held to maturity securities 965,000 534,000 965,000 534,000 Sales of available for sale securities 0 8,336,000 1,748,000 8,336,000 Purchases of premises and equipment, net (2,195,000) (1,997,000) (3,774,000) (2,548,000) Purchases of bank owned life insurance policies 0 0 0 (300,000) ------------- ------------- ------------- ------------- Net cash used in investing activities (86,380,000) (58,291,000) (158,589,000) (105,040,000) CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits 50,735,000 42,490,000 143,177,000 89,474,000 Net increase (decrease) in securities sold under agreements to repurchase 5,347,000 (5,548,000) (2,585,000) (10,645,000) Advances from Federal Home Loan Bank 20,000,000 30,000,000 30,000,000 30,000,000 Net increase (decrease) in other borrowed money 7,053,000 (1,917,000) 1,300,000 346,000 Stock option exercises 39,000 7,000 127,000 27,000 Employee stock purchase plan 22,000 14,000 38,000 24,000 Cash dividend reinvestment plan 46,000 14,000 65,000 14,000 Payment of cash dividends (646,000) (433,000) (1,258,000) (866,000) Cash paid in lieu of fractional shares on stock dividend 0 0 (4,000) 0 ------------- ------------- ------------- ------------- Net cash from financing activities 82,596,000 64,627,000 170,860,000 108,374,000 ------------- ------------- ------------- ------------- Net change in cash and cash equivalents 307,000 9,045,000 19,408,000 9,222,000 Cash and cash equivalents at beginning of period 35,665,000 28,294,000 16,564,000 28,117,000 ------------- ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 35,972,000 $ 37,339,000 $ 35,972,000 $ 37,339,000 ============= ============= ============= ============= Cash paid during the period for: Interest $ 6,232,000 $ 6,294,000 $ 12,183,000 $ 11,724,000 Federal income tax 2,550,000 2,350,000 2,925,000 2,575,000
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 six months ended June 30, 2004 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 four subsidiaries, Mercantile Bank Mortgage Company, LLC ("our mortgage company"), Mercantile BIDCO, Inc. ("our BIDCO"), Mercantile Bank Real Estate Co., LLC ("our real estate company"), and Mercantile Insurance Center, Inc. ("our insurance center"). 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 June 30, 2004 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, 2003. MBWM Capital Trust I ("the trust"), a business trust formed by Mercantile Bank Corporation, sold 1.6 million trust preferred securities at $10.00 per trust preferred security in a September 1999 offering. Mercantile Bank Corporation issued subordinated debentures to the trust in exchange for the proceeds of the offering. The debentures and related debt issuance costs represent the sole assets of the trust. Prior to 2004, the trust was consolidated in our financial statements, with the trust preferred securities issued by the trust reported in liabilities as "Trust preferred securities" and the subordinated debentures eliminated in the consolidation. Under new accounting guidance, FASB Interpretation No. 46, as revised in December 2003, the trust is no longer consolidated. Accordingly, Mercantile Bank Corporation does not report the securities issued by the trust as liabilities, and instead reports as liabilities the subordinated debentures issued by Mercantile Bank Corporation and held by the trust, as these are no longer eliminated in consolidation. Amounts previously reported as "Trust preferred securities" in liabilities has been recaptioned "Subordinated debentures" and continue to be presented in liabilities on the balance sheet. The effect of no longer consolidating the trust does not significantly change the amounts reported as Mercantile Bank Corporation's assets, liabilities, equity or interest expense. Stock Dividend: All per share amounts and average shares outstanding have been adjusted for all periods presented to reflect the 5% stock dividend distributed on May 3, 2004. The Statement of Changes in Shareholders' Equity reflects a transfer from retained earnings to common stock for the value of the shares distributed. 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 uncollectibility of a loan or lease balance is confirmed. 7 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SIGNIFICANT ACCOUNTING POLICIES (Continued) 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.
Quarter ended Six months ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- Net income as reported $ 3,146,000 $ 2,540,000 $ 6,119,000 $ 4,773,000 Deduct: Stock-based compensation expense determined under fair value based method 63,000 81,000 126,000 163,000 ------------- ------------- ------------- ------------- Pro forma net income 3,083,000 2,459,000 5,993,000 4,610,000 ============= ============= ============= ============= Basic earnings per share as reported $ 0.44 $ 0.45 $ 0.85 $ 0.84 Pro forma basic earnings per share 0.43 0.43 0.84 0.81 Diluted earnings per share as reported $ 0.43 $ 0.44 $ 0.84 $ 0.82 Pro forma diluted earnings per share 0.42 0.42 0.82 0.79
The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of grant date.
Quarter ended Six months ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- Risk-free interest rate 3.25% 3.25% 3.25% 3.25% Expected option life 7 Years 7 Years 7 Years 7 Years Expected stock price volatility 22% 20% 22% 20% Dividend yield 1.00% 1.30% 1.00% 1.30%
8 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 2. LOANS AND LEASES Our total loans and leases at June 30, 2004 were $1,185.4 million compared to $1,036.0 million at December 31, 2003, an increase of $149.4 million, or 14.4%. The components of our outstanding balances at June 30, 2004 and December 31, 2003, and the percentage changes in loans and leases from the end of 2003 to the end of the second quarter 2004 are as follows:
Percent June 30, 2004 December 31, 2003 Increase/ Balance % Balance % (Decrease) ------- - ------- - ---------- Real Estate: Construction and land development $ 119,086,000 10.0% $ 117,649,000 11.4% 1.2% Secured by 1-4 family properties 107,603,000 9.1 92,339,000 8.9 16.5 Secured by multi-family properties 34,312,000 2.9 28,950,000 2.8 18.5 Secured by nonresidential properties 575,757,000 48.6 485,080,000 46.8 18.7 Commercial 341,067,000 28.8 304,800,000 29.4 11.9 Leases 2,381,000 0.2 2,309,000 0.2 3.1 Consumer 5,157,000 0.4 4,836,000 0.5 6.6 --------------- ----- --------------- ----- ---- Total loans and leases $ 1,185,363,000 100.0% $ 1,035,963,000 100.0% 14.4% =============== ===== =============== ===== ====
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 six months ended June 30:
Three months ended Six months ended June 30, June 30, June 30, June 30, 2004 2003 2004 2003 ---- ---- ---- ---- Balance at beginning of period $ 15,337,000 $ 11,406,000 $ 14,379,000 $ 10,890,000 Charge-offs (264,000) (297,000) (562,000) (429,000) Recoveries 9,000 204,000 21,000 227,000 Provision for loan and lease losses 1,230,000 845,000 2,474,000 1,470,000 ------------- ------------- ------------- -------------- Balance at June 30 $ 16,312,000 $ 12,158,000 $ 16,312,000 $ 12,158,000 ============= ============= ============= ==============
9 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 4. PREMISES AND EQUIPMENT - NET Premises and equipment are comprised of the following:
June 30, December 31, 2004 2003 ---- ---- Land and improvements $ 5,753,000 $ 5,745,000 Buildings and leasehold improvements 11,730,000 8,183,000 Furniture and equipment 5,154,000 4,935,000 ------------- ------------- 22,637,000 18,863,000 Less accumulated depreciation 4,169,000 3,558,000 ------------- ------------- Premises and equipment, net $ 18,468,000 $ 15,305,000 ============= =============
Depreciation expense amounted to $307,000 during the second quarter of 2004, compared to $285,000 in the second quarter of 2003. Depreciation expense amounted to $610,000 during the first six months of 2004, compared to $551,000 during the first six months of 2003. 5. DEPOSITS Our total deposits at June 30, 2004 were $1,046.1 million compared to $902.9 million at December 31, 2003, an increase of $143.2 million, or 15.9%. The components of our outstanding balances at June 30, 2004 and December 31, 2003, and percentage change in deposits from the end of 2003 to the end of the second quarter 2004 are as follows:
Percent June 30, 2004 December 31, 2003 Increase/ Balance % Balance % (Decrease) ------- - ------- - --------- Noninterest-bearing demand $ 114,441,000 10.9% $ 76,579,000 8.5% 49.4% Interest-bearing checking 30,411,000 2.9 34,241,000 3.8 (12.7) Money market 8,254,000 0.8 8,290,000 0.9 (0.4) Savings 129,233,000 12.4 101,710,000 11.3 27.1 Time, under $100,000 7,436,000 0.7 8,163,000 0.9 (8.9) Time, $100,000 and over 83,439,000 8.0 82,288,000 9.1 1.4 --------------- ----- ------------- ----- ----- 373,214,000 35.7 311,271,000 34.5 19.9 Out-of-area time, under $100,000 102,060,000 9.8 98,079,000 10.9 4.1 Out-of-area time, $100,000 and over 570,795,000 54.5 493,542,000 54.6 15.7 --------------- ----- ------------- ----- ----- 672,855,000 64.3 591,621,000 65.5 13.7 --------------- ----- ------------- ----- ----- Total deposits $ 1,046,069,000 100.0% $ 902,892,000 100.0% 15.9% =============== ===== ============= ===== =====
10 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 6. SHORT-TERM BORROWINGS Information relating to our securities sold under agreements to repurchase follows:
June 30, December 31, 2004 2003 ---- ---- Outstanding balance at end of period $46,960,000 $49,545,000 Average interest rate at end of period 1.38% 1.38% Average balance during the period $46,373,000 $45,865,000 Average interest rate during the period 1.39% 1.45% Maximum month end balance during the period $50,138,000 $55,270,000
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 June 30, 2004 and December 31, 2003 were as follows.
June 30, December 31, 2004 2003 ---- ---- Maturities July 2004 through September 2006, fixed rates from 1.46% to 3.21%, averaging 2.14% $110,000,000 0 Maturities in May 2006, floating rates tied to Libor indices, averaging 1.33% as of June 30, 2004 10,000,000 0 Maturities January 2004 through September 2006, fixed rates from 1.54% to 3.21%, averaging 2.07% 0 $ 90,000,000 ------------ ------------ Total Federal Home Loan Bank advances $120,000,000 $ 90,000,000 ============ ============
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 June 30, 2004 totaled $182.5 million, with availability approximating $54.0 million. 11 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 7. FEDERAL HOME LOAN BANK ADVANCES (Continued) Maturities of FHLB advances currently outstanding during the next five years are: 2004 $ 30,000,000 2005 55,000,000 2006 35,000,000 2007 0 2008 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 contractual amounts of our financial instruments with off-balance-sheet risk at June 30, 2004 and December 31, 2003 follows:
June 30, December 31, 2004 2003 ---- ---- Commercial unused lines of credit $194,927,000 $176,943,000 Unused lines of credit secured by 1-4 family residential properties 23,385,000 19,020,000 Credit card unused lines of credit 11,234,000 8,990,000 Other consumer unused lines of credit 6,964,000 5,569,000 Commitments to make loans 47,322,000 73,570,000 Standby letters of credit 57,138,000 57,918,000 ------------ ------------ Total loan and leases commitments $340,970,000 $342,010,000 ============ ============
12 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 9. 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 not well 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 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 ------ ----- ------ ----- ------ ----- June 30, 2004 Total capital (to risk weighted assets) Consolidated $167,380 12.7% $105,165 8.0% $131,456 10.0% Bank 163,709 12.5 104,922 8.0 131,153 10.0 Tier 1 capital (to risk weighted assets) Consolidated 151,068 11.5 52,582 4.0 78,874 6.0 Bank 147,397 11.2 52,461 4.0 78,692 6.0 Tier 1 capital (to average assets) Consolidated 151,068 11.4 53,221 4.0 66,526 5.0 Bank 147,397 11.1 53,121 4.0 66,401 5.0
13 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 9. REGULATORY MATTERS (Continued)
Minimum Required to be Well Minimum Required Capitalized Under for Capital Prompt Corrective Actual Adequacy Purposes Action Regulations ------------------- -------------------- -------------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- December 31, 2003 Total capital (to risk weighted assets) Consolidated $160,360 13.8% $ 92,711 8.0% $115,888 10.0% Bank 156,950 13.6 92,556 8.0 115,695 10.0 Tier 1 capital (to risk weighted assets) Consolidated 145,981 12.6 46,356 4.0 69,533 6.0 Bank 142,571 12.3 46,278 4.0 69,417 6.0 Tier 1 capital (to average assets) Consolidated 145,981 12.5 46,756 4.0 58,444 5.0 Bank 142,571 12.2 46,703 4.0 58,378 5.0
Our capital levels as of June 30, 2004 include the $16.0 million in 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 our Tier 1 capital to 25% of total Tier 1 capital. As of June 30, 2004, 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 April 7, 2004, that was distributed on May 3, 2004 to record holders as of April 16, 2004. All earnings per share and dividend per share information have been adjusted for the 5% stock dividend. We have also paid two cash dividends on our common stock during 2004. On January 6, 2004, we declared a $0.09 per share cash dividend on our common stock, which was paid on March 10, 2004 to record holders as of February 10, 2004. On April 7, 2004, we declared a $0.09 per share cash dividend on our common stock, which was paid on June 10, 2004 to record holders as of May 10, 2004. On July 7, 2004, we declared a $0.09 per share cash dividend on our common stock, which is payable on September 10, 2004 to record holders as of August 10, 2004. 10. 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; however, the plan allows for shares to be purchased directly from us or on the open market. During the six months ended June 30, 2004, we issued 1,094 shares under the plan. 14 MERCANTILE BANK CORPORATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION 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, among others, 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 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 four subsidiaries Mercantile Bank Mortgage Company ("our mortgage company"), Mercantile BIDCO, Inc. ("our BIDCO"), Mercantile Bank Real Estate Co., LLC ("our real estate company") and Mercantile Insurance Center, Inc. ("our insurance center"), at June 30, 2004 to December 31, 2003 and the results of operations for the three and six months ended June 30, 2004 and June 30, 2003. 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. 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-27 through F-31 in our Form 10-K for the fiscal year ended December 31, 2003 (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. 15 MERCANTILE BANK CORPORATION 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 uncollectibility 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 six months of 2004, our assets increased from $1,203.3 million on December 31, 2003, to $1,378.6 million on June 30, 2004. This represents a total increase in assets of $175.3 million, or 14.6%. The asset growth was comprised primarily of a $147.5 million increase in net loans, an increase of $19.4 million in cash and cash equivalents and a $3.4 million increase in securities. The increase in assets was primarily funded by a $143.2 million growth in deposits and an increase of $30.0 million in Federal Home Loan Bank advances. Commercial loans and leases increased by $133.8 million during the first six months of 2004, and at June 30, 2004 totaled $1,072.6 million, or 90.5% 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 15 commercial lenders have over 220 years of combined commercial lending experience, ten of whom have 15 years or more experience. Of each of the loan categories that we originate, commercial loans and leases are most efficiently originated and managed; thus limiting overhead costs by necessitating the attention of fewer full-time employees. Our commercial lending business generates the greatest amount of local deposits, and is our primary source of demand deposits. Residential mortgage loans and consumer loans increased by $15.3 million and $0.3 million, respectively, during the first six months of 2004. As of June 30, 2004, residential mortgage and consumer loans totaled a combined $112.8 million, or 9.5% 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 our lending efforts and resultant assets to remain the dominant loan portfolio category. 16 MERCANTILE BANK CORPORATION Management believes the quality of our loan and lease portfolio remains strong. Net loan and lease charge-offs during the first six months of 2004 totaled $541,000, or 0.10% of average total loans and leases on an annualized basis. During the first six months of 2003, net loan and lease charge-offs totaled $202,000, or 0.05% of average total loans and leases on an annualized basis. Past due and nonaccrual loans and leases at June 30, 2004 totaled $3.7 million, or 0.31% of period-ending total loans and leases. At December 31, 2003, past due and nonaccrual loans and leases totaled $1.8 million, or 0.17% of period-ending total loans and leases. The $1.9 million increase during the first six months of 2004, as well as a vast majority of the $541,000 net loan and lease charge-off figure noted above, is primarily attributable to two commercial loan relationships. 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 net 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 $3.4 million during the first six months of 2004. Purchases during the first six months of 2004 totaled $19.0 million. Proceeds from the sales of securities totaled $1.7 million, while proceeds from the maturities, calls and repayments of securities totaled $12.3 million. At June 30, 2004, the net unrealized loss on available for sale securities equaled $1.0 million, compared to a net unrealized gain of $0.3 million at December 31, 2003. Our securities portfolio consists of U.S. Government Agency bonds, mortgage-backed securities issued or guaranteed by U.S. Governments Agencies, investment-grade tax-exempt municipal securities and Federal Home Loan Bank of Indianapolis ("FHLBI") stock. Cash and cash equivalents increased $19.4 million during the first six months of 2004, totaling $36.0 million on June 30, 2004. Cash and due from bank balances were up $18.7 million, with short-term investments up $0.7 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 cash and cash equivalents during the first six months of 2004 equaled $34.0 million, well above the relatively low balance of $16.6 million on December 31, 2003. Premises and equipment at June 30, 2004 equaled $18.5 million, an increase of $3.2 million since December 31, 2003, and an increase of $6.0 million since March 31, 2003. The vast majority of the increase relates to our construction of two new banking facilities. 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, Michigan for $1.3 million. The building was demolished, and we are now in the construction phase of building a new four-story facility on this property. This facility will serve as the new location for our current downtown leased facility, which includes our commercial lending function, and will house the administration and loan operations functions currently housed at other of our locations. Expected completion date is mid-2005. On September 29, 2003, our bank purchased ten acres of land located in Holland, Michigan for $0.9 million. We are now in the construction phase of building a new two-story facility on this property. This facility will serve as the new location for our current full-service branch and lending office which currently operates out of a leased facility. Expected completion date is late-2004. 17 MERCANTILE BANK CORPORATION Deposits increased $143.2 million during the first six months of 2004, totaling $1,046.1 million at June 30, 2004. Local deposits increased $61.9 million, or 19.9% and out-of-area deposits increased $81.3 million. As a percent of total deposits, local deposits increased from 34.5% on December 31, 2003, to 35.7% on June 30, 2004. Noninterest-bearing demand deposits, comprising 10.9% of total deposits, increased $37.8 million during the first six months of 2004. Savings deposits (12.4% of total deposits) increased $27.5 million, interest-bearing checking deposits (2.9% of total deposits) decreased $3.8 million and money market deposit accounts (0.8% of total deposits) was relatively unchanged during the first six months of 2004. Local certificates of deposit, comprising 8.7% of total deposits, increased by $0.4 million during the first six months of 2004. Out-of-area deposits increased $81.3 million during the first six months of 2004, totaling $672.9 million as of June 30, 2004. 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 deposit interest rates that would have to be offered in the local market to generate a sufficient level of funds. During the first six months of 2004 rates paid on new out-of-area certificates of deposit were generally about the same as rates paid on new certificates of deposit issued to local customers. 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, our relatively high reliance on out-of-area deposits will likely continue. Securities sold under agreements to repurchase ("repurchase agreements") decreased by $2.6 million during the first six months of 2004, totaling $47.0 million as of June 30, 2004. 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 $30.0 million during the first six months of 2004, totaling $120.0 million as of June 30, 2004. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans and 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 June 30, 2004 totaled $182.5 million, with availability of approximately $54.0 million. FHLBI advances, along with out-of-area deposits, are the primary components of our wholesale funding program. 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. 18 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 our market area have generally 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 primarily of certificates of deposit from customers outside of our market area and advances from the FHLBI, totaled $792.9 million, or 64.1% of combined deposits and borrowed funds as of June 30, 2004. As of December 31, 2003, wholesale funds totaled $681.6 million, or 63.9% of combined deposits and borrowed funds. Reliance on wholesale funds is expected to continue due to our anticipated future asset growth. As a member of the FHLBI, our bank has access to the FHLBI's borrowing programs. At June 30, 2004, advances from the FHLBI totaled $120.0 million, up from the $90.0 million outstanding at December 31, 2003. Based on available collateral at June 30, 2004, our bank could borrow an additional $54.0 million. Our bank has the ability to borrow money on a daily basis through correspondent banks via established unsecured federal funds purchased lines, totaling $50.0 million as of June 30, 2004. The average balance of federal funds purchased during the first six months of 2004 equaled $6.0 million, compared to a $5.7 million average federal funds sold position during the same time period. 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 June 30, 2004, our bank had a total of $283.8 million in unfunded loan commitments and $57.1 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $236.5 million were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and $47.3 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 our overall liquidity. CAPITAL RESOURCES Shareholders' equity is a noninterest-bearing source of funds that provides support for asset growth. Shareholders' equity increased by $4.1 million during the first six months of 2004, from $130.2 million on December 31, 2003, to $134.3 million at June 30, 2004. The increase is primarily attributable to net income of $6.1 million recorded during the first six months of 2004. Shareholders' equity was negatively impacted during the first six months of 2004 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. Shareholders' equity also increased $0.2 million from the issuance of 29,802 new shares of common stock resulting from our dividend reinvestment plan, employee stock purchase plan and stock option exercises. 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. The capital ratios of the company and our bank as of June 30, 2004 and December 31, 2003 are disclosed under Note 9 of the Notes to Consolidated Financial Statements. 19 MERCANTILE BANK CORPORATION 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 April 7, 2004, that was distributed on May 3, 2004 to record holders as of April 16, 2004. We paid a $0.09 per share cash dividend on our common stock on March 10, 2004 and June 10, 2004. On July 7, 2004, we declared a $0.09 per share cash dividend payable on September 10, 2004, to record holders as of August 10, 2004. RESULTS OF OPERATIONS Net income for the second quarter of 2004 was $3.1 million ($0.44 per basic share and $0.43 per diluted share), which represents a 23.9% increase over net income of $2.5 million ($0.45 per basic share and $0.44 per diluted share) recorded during the second quarter of 2003. Net income for the first six months of 2004 was $6.1 million ($0.85 per basic share and $0.84 per diluted share), which represents a 28.2% increase over net income of $4.8 million ($0.84 per basic share and $0.82 per diluted share) recorded during the first six months of 2003. Per share amounts reflect the dilutive impact of the common stock sale completed during the latter part of 2003, with average shares outstanding up 25.7% in the second quarter of 2004 and year-to-date 2004 when compared to the same time periods in 2003. The improvement in net income during both time periods is primarily due to an increase in net interest income and greater operating efficiency. Interest income during the second quarter of 2004 was $16.1 million, an increase of 20.1% over the $13.4 million earned during the second quarter of 2003. Interest income during the first six months of 2004 was $31.5 million, an increase of 20.6% over the $26.1 million earned during the first six months of 2003. 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 second quarter of 2004 earning assets averaged $1,269.3 million, $315.4 million higher than average earning assets of $953.9 million during the second quarter of 2003. Average loans were up $302.4 million and securities increased $17.2 million. During the first six months of 2004, earning assets averaged $1,233.1 million, $309.7 million higher than average earning assets of $923.4 million during the same time period in 2003. Average loans were up $291.7 million and securities increased $18.4 million. Negatively impacting the growth in interest income was the decline in yield on earning assets. During the second quarter of 2004 and 2003, earning assets had a weighted average yield (tax equivalent-adjusted basis) of 5.17% and 5.73%, respectively. During the first six months of 2004 and 2003 earning assets had a weighted average yield of 5.21% and 5.86%, respectively. The decrease in weighted average yields during both time periods is primarily due to the decline in market interest rates. Interest expense during the second quarter of 2004 was $6.1 million, an increase of 3.3% over the $5.9 million expensed during the second quarter of 2003. Interest expense during the first six months of 2004 was $12.0 million, an increase of 1.4% over the $11.8 million expensed during the first six months of 2003. The relatively small increase in interest expense is primarily attributable to the decline in the cost of funds, which offset a vast majority of the impact of increased funding liabilities necessitated by the growth in assets. During the second quarter of 2004, interest-bearing liabilities averaged $1,104.1 million, $248.8 million higher than average interest-bearing liabilities of $855.3 million during the second quarter of 2003. Interest-bearing deposits were up $166.4 million and FHLBI advances increased $72.5 million. During the first six months of 2004, interest-bearing liabilities averaged $1,073.7 million, $247.2 million higher than average interest-bearing liabilities of $826.5 million during the same time period in 2003. Interest-bearing deposits were up $161.3 million and FHLBI advances increased $78.5 million. During the second quarter of 2004 and 2003, interest-bearing liabilities had a weighted average rate of 2.23% and 2.78%, respectively. During the first six months of 2004 and 2003, interest-bearing liabilities had a weighted average rate of 2.25% and 2.88%, respectively. The decrease in the weighted average cost of interest-bearing liabilities during both time periods is primarily due to the decline in market interest rates. 20 MERCANTILE BANK CORPORATION Net interest income during the second quarter of 2004 was $10.0 million, an increase of 33.4% over the $7.5 million earned during the second quarter of 2003. Net interest income during the first six months of 2004 was $19.5 million, an increase of 36.5% over the $14.3 million earned during the same time period in 2003. The increase in net interest income is primarily due to the growth in earning assets, combined with a steady to slightly improving net interest margin. The net interest margin during the second quarter of 2004 was 3.24%, unchanged from the level during the second quarter of 2003. During the first six months of 2004 the net interest margin was 3.25%, compared to 3.21% during the same time period in 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 second quarter of 2004 and 2003. 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 35%. Securities interest income was increased by $234,000 and $193,000 in the second quarter of 2004 and 2003, respectively, for this adjustment.
Quarters ended June 30, ----------------------- 2 0 0 4 2 0 0 3 ------- ------- Average Average Average Average Balance Interest Rate Balance Interest Rate ------------- ------------- ----------- -------------- ------------- ------ (dollars in thousands) ASSETS Loans and leases $ 1,144,758 $ 14,722 5.16% $ 842,370 $ 12,223 5.82% Securities 120,632 1,634 5.42 103,480 1,379 5.36 Federal funds sold 3,282 8 0.94 7,796 23 1.20 Short term investments 627 0 0.30 205 1 0.75 ------------- ------------- ------------- ------------- Total interest-earning assets 1,269,299 16,364 5.17 953,851 13,626 5.73 Allowance for loan losses (15,787) (11,845) Other assets 76,995 60,708 ------------- ------------- Total assets $ 1,330,507 $ 1,002,714 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits $ 918,006 $ 4,929 2.15% $ 751,592 $ 5,165 2.76% Short-term borrowings 55,142 186 1.35 45,774 173 1.52 FHLB advances 113,077 597 2.08 40,604 183 1.78 Long-term borrowings 17,878 418 9.35 17,365 413 9.51 ------------- ------------- ------------- ------------- Total interest-bearing liabilities 1,104,103 6,130 2.23 855,335 5,934 2.78 Noninterest-bearing deposits 86,645 58,394 Other liabilities 6,548 6,579 Shareholders' equity 133,211 82,406 ------------- ------------- Total liabilities and shareholders' equity $ 1,330,507 $ 1,002,714 ============= ------------- ============= ------------- Net interest income $ 10,234 $ 7,692 ============= ============= Net interest rate spread 2.94% 2.95% ======== ====== Net interest rate spread on average assets 3.08% 3.08% ======== ====== Net interest margin on earning assets 3.24% 3.24% ======== ======
21 MERCANTILE BANK CORPORATION Provisions to the allowance for loan and lease losses during the second quarter of 2004 were $1.2 million, compared to the $0.8 million that was expensed during the second quarter of 2003. Provisions to the allowance for loan and lease losses during the first six months of 2004 were $2.5 million, compared to the $1.5 million that was expensed during the same time period in 2003. The increase during both time periods primarily reflects the higher volume of loan and lease growth and net loan and lease charge-offs. Loan and lease growth during the second quarter of 2004 was $74.2 million, compared to loan and lease growth of $53.5 million during the second quarter of 2003. Loan and lease growth during the first six months of 2004 was $149.4 million, compared to loan and lease growth of $94.4 million during the same time period in 2003. Net loan and lease charge-offs of $255,000 were recorded during the second quarter of 2004, compared to net loan and lease charge-offs of $93,000 during the second quarter of 2003. During the first six months of 2004 net loan and lease charge-offs totaled $541,000, compared to net loan and lease charge-offs of $202,000 during the same time period in 2003. The allowance for loan and lease losses as a percentage of total loans outstanding as of June 30, 2004 was 1.38%, compared to 1.40% at June 30, 2003. 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 Allowance 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. The Allowance Analysis, used since the inception of our bank and completed monthly, applies reserve allocation factors to outstanding loan and lease 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 Allowance Analysis is reviewed regularly by senior management and the Board of Directors and is adjusted periodically based upon identifiable trends and experience. 22 MERCANTILE BANK CORPORATION Noninterest income during the second quarter of 2004 was $1.0 million, compared to the $1.2 million earned during the second quarter of 2003. Noninterest income during the first six months of 2004 was $2.0 million, compared to the $2.2 million earned during the same time period in 2003. The declines during both time periods primarily results from a lower level of income from mortgage banking activities and a decline in gains on the sales of securities, which was only partially offset by increased fee income on other products and services. Primarily reflecting the opening of new accounts and adjustments in our deposit fee structure, service charge income on deposits and repurchase agreements increased $32,000 during the second quarter of 2004 when compared to the second quarter of 2003, and were up $62,000 during the first six months of 2004 when compared to the same time period in 2003. Primarily reflecting an accounting change in recognizing fee income and an increase in the dollar volume of commercial letters of credit outstanding, commercial letter of credit fees increased $70,000 during the second quarter of 2004 when compared to the second quarter of 2003, and were up $137,000 during the first six months of 2004 when compared to the same time period in 2003. Primarily reflecting an increased interest rate environment and resulting decrease in residential mortgage loan refinancings, residential mortgage loan fees decreased $208,000 during the second quarter of 2004 when compared to the second quarter of 2003, and decreased $353,000 during the first six months of 2004 when compared to the same time period in 2003. There were no securities gains during the second quarter of 2004 compared to securities gains of $212,000 recorded during the second quarter of 2003, and totaled $78,000 during the first six months of 2004 compared to $212,000 during the same time period in 2003. Noninterest expense during the second quarter of 2004 was $5.4 million, compared to the $4.4 million expensed during the second quarter of 2003. Noninterest expense during the first six months of 2004 was $10.6 million, compared to the $8.4 million expensed during the same time period in 2003. Employee salary and benefit expenses were $0.8 million higher during the second quarter of 2004 than the level expensed during the second quarter of 2003, and were $1.5 million higher during the first six months of 2004 than the level expensed during the first six months of 2003. 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 147 at June 30, 2003 to 183 as of June 30, 2004. Other overhead costs, including occupancy and fixed asset costs, increased $288,000 in the second quarter of 2004 over the level expensed in the second quarter of 2003, and increased $628,000 during the first six months of 2004 over the level expensed during the first six months of 2003, primarily reflecting the additional expenses required to administer our significantly increased asset base and staff. 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 $1.0 million during the second quarter of 2004 over the amount expensed during the second quarter of 2003, and increased by $2.2 million during the first six months of 2004 over the amount expensed during the first six months of 2003. However, net revenues (net interest income plus noninterest income) increased at a substantially higher level of $2.3 million and $5.0 million during the same time periods, respectively. Federal income tax expense was $1.2 million and $2.4 million during the second quarter and first six months of 2004, respectively. Federal income tax expense was $1.0 million and $1.9 million during the second quarter and first six months of 2003, respectively. The increases during both time periods primarily results from the increase in net income before federal income tax. 23 MERCANTILE BANK CORPORATION 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 June 30, 2004 (dollars in thousands): 24 MERCANTILE BANK CORPORATION
Within Three to One to After Three Twelve Five Five Months Months Years Years Total ------ ------ ----- ----- ----- Assets: Commercial loans and leases (1) $ 501,036 $ 32,322 $ 488,306 $ 50,939 $ 1,072,603 Residential real estate loans 51,968 3,775 37,199 14,661 107,603 Consumer loans 1,164 559 3,306 128 5,157 Investment securities (2) 6,817 1,271 19,507 97,266 124,861 Short-term investments 967 967 Allowance for loan and leases losses (16,312) (16,312) Other assets 83,747 83,747 ------------- ------------- ------------- ------------- ------------- Total assets 561,952 37,927 548,318 230,429 1,378,626 Liabilities: Interest-bearing checking 30,411 30,411 Savings 129,233 129,233 Money market accounts 8,254 8,254 Time deposits < $100,000 38,750 40,286 30,460 109,496 Time deposits $100,000 and over 135,335 327,378 191,521 654,234 Short-term borrowings 53,960 53,960 FHLB advances 20,000 45,000 55,000 120,000 Long-term borrowings 1,414 16,495 17,909 Noninterest-bearing checking 114,441 114,441 Other liabilities 6,416 6,416 ------------- ------------- ------------- ------------- ------------- Total liabilities 417,357 412,664 276,981 137,352 1,244,354 Shareholders' equity 134,272 134,272 ------------- ------------- ------------- ------------- ------------- Total sources of funds 417,357 412,664 276,981 271,624 1,378,626 ------------- ------------- ------------- ------------- ------------- Net asset (liability) GAP $ 144,595 $ (374,737) $ 271,337 $ (41,195) ============= ============= ============= ============= Cumulative GAP $ 144,595 $ (230,142) $ 41,195 ============= ============= ============= Percent of cumulative GAP to total assets 10.5% (16.7)% 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 next repricing date. (2) Mortgage-backed securities are categorized by expected final maturities based upon prepayment trends as of June 30, 2004 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 the company's strategies, among other factors. 25 MERCANTILE BANK CORPORATION We conducted multiple simulations as of June 30, 2004, 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 is 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 $ (2,621,000) (6.2)% Interest rates down 100 basis points (1,513,000) (3.6) No change in interest rates (791,000) (1.9) Interest rates up 100 basis points 323,000 0.8 Interest rates up 200 basis points 1,445,000 3.4
The results detailed above have been influenced by the basis risk contained within our earning assets and interest-bearing liabilities. Interest rates on our floating rate loans, comprising approximately 67% of total assets as of June 30, 2004, are tied to the prime rate. Interest rates on our wholesale funds, and to a lesser degree on our local interest-bearing deposits, closely mirror U.S. Treasury and Libor interest rates. During the second quarter of 2004, U.S. Treasury and Libor interest rates increased, reflecting the interest rate market's expectations that the Federal Reserve was set to begin increasing short term interest rates. For example, although as of June 30, 2004, the Federal Reserve had not yet begun to increase the federal funds rate, the interest rate on one year brokered CDs and FHLB bullet advances had increased by about 75 basis points during the second quarter of 2004. In conducting the net interest income simulation we used brokered CD and FHLB bullet advance rates in effect as of June 30, 2004. Therefore, it is likely that future net interest income would be higher than what is detailed above. 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 June 30, 2004, 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 June 30, 2004. 26 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, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES On May 7, 2004, we issued 2,650 shares of our common stock to one of our employees upon their exercise of employee stock options issued under our 1997 Employee Stock Option Plan. We received a weighted average exercise price of $10.695 per share aggregating $28,341.75. The exercise price for these shares was substantially paid by the employee delivering to us common stock of the company that he already owned having an aggregate value of $28,310.98, with the difference paid in cash. The shares issued under the 1997 Employee Stock Option Plan 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. Issuer Purchases of Equity Securities
(c) Total Number of (a) Total Shares Purchased as (d) Maximum Number of Number of (b) Average Part of Publicly Shares that May Yet Be Shares Price Paid Announced Plans or Purchased Under the Period Purchased Per Share Programs Plans or Programs ------ --------- --------- -------- ----------------- April 1 - 30 909 $ 36.475 0 0 May 1 - 31 818 34.610 0 0 June 1 - 30 0 N/A 0 0 ----- ------ - - Total 1,727 35.592 0 0 ----- ------ - -
The shares shown in column (a) above as having been purchased were acquired from three of our employees when they used shares of common stock that they already owned to pay part of the exercise price when exercising stock options issued under our employee stock option plans. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At our Annual Meeting held on April 22, 2004, our shareholders voted to elect five directors, Edward J. Clark, C. John Gill, Gerald R. Johnson Jr., Calvin D. Murdock and Donald Williams Sr., each for a three year term expiring at the Annual Meeting of the shareholders of the company in 2007. The results of the election were as follows:
Votes Votes Votes Broker Nominee For Against Withheld Non-Votes ------- --- ------- -------- --------- Edward J. Clark 6,044,123 0 59,852 0 C. John Gill 5,888,038 0 215,937 0 Gerald R. Johnson, Jr. 5,992,592 0 111,383 0 Calvin D. Murdock 6,039,726 0 64,249 0 Donald Williams, Sr. 6,025,623 0 78,352 0
27 The terms of office of the following directors (who were not up for election) continued after the Annual Meeting: Betty S. Burton, David M. Cassard, Peter A. Cordes, Doyle A. Hayes, David M. Hecht, Susan K. Jones, Lawrence W. Larsen, Michael H. Price and Dale J. Visser. At our Annual Meeting held on April 22, 2004, our shareholders voted to amend the Articles of Incorporation of the company to increase the authorized common stock of the company from 9,000,000 shares to 20,000,000 shares. The results of the vote were as follows:
Votes Votes Votes Broker For Against Abstained Non-Votes --- ------- --------- --------- 5,320,908 762,550 20,516 0
At our Annual Meeting held on April 22, 2004, our shareholders voted to approve the 2004 Employee Stock Option Plan (the "Plan"). The plan provides for the grant of options to acquire shares of our common stock, not to exceed 250,000 shares, to officers and other employees of the company and its subsidiaries. The results of the vote were as follows:
Votes Votes Votes Broker For Against Abstained Non-Votes --- ------- --------- --------- 4,340,581 277,320 88,268 1,397,896
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 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 second quarter of 2004, the Company furnished to the Securities and Exchange Commission the following report on Form 8-K: i) Dated April 8, 2004, pertaining to the Company's press release issued on April 8, 2004 reporting financial results and earnings for its first quarter of 2004 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 August 6, 2004. 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 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
31