-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GYdCzhIrlMfpqTLTNwx9Gx6DjbNk7UOpklS1tMM8IlqBsyPBsY5bIpawjlQWbqC3 e8rtswN2MnXLZRI7VQoZ5A== 0000950124-05-001496.txt : 20050315 0000950124-05-001496.hdr.sgml : 20050315 20050315064840 ACCESSION NUMBER: 0000950124-05-001496 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050315 DATE AS OF CHANGE: 20050315 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MERCANTILE BANK CORP CENTRAL INDEX KEY: 0001042729 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 383360865 STATE OF INCORPORATION: MI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-26719 FILM NUMBER: 05680005 BUSINESS ADDRESS: STREET 1: 5650 BYRON CENTER AVENUE S. W. CITY: WYOMING STATE: MI ZIP: 49509 BUSINESS PHONE: 616 406-3777 MAIL ADDRESS: STREET 1: 5650 BYRON CENTER AVENUE S. W. CITY: WYOMING STATE: MI ZIP: 49509 10-K 1 k92009e10vk.txt ANNUAL REPORT FOR FISCAL YEAR ENDED DECEMBER 31, 2004 U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-K [X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________ to __________________ Commission File Number 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 Number) Incorporation or Organization)
5650 BYRON CENTER AVENUE SW, WYOMING, MICHIGAN 49519 (Address of Principal Executive Offices) (Zip Code)
(616) 406-3777 (Registrant's Telephone Number including area code) Securities Registered Pursuant to Section 12(b) of the Act: NONE Securities Registered Pursuant to Section 12(g) of the Act: COMMON STOCK (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 requirements for the past 90 days. YES X NO ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES X NO ----- ----- The aggregate value of the common equity held by non-affiliates (persons other than directors and executive officers) of the Registrant, computed by reference to the average of the closing bid and asked prices of the common stock as of the last business day of the Registrant's most recently completed second quarter, was approximately $239.2 million. As of February 10, 2005, there were issued and outstanding 7,210,743 shares of the Registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the 2005 Annual Meeting of Shareholders (Portions of Part III). PART I ITEM 1. BUSINESS THE COMPANY Mercantile Bank Corporation is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). Unless the text clearly suggests otherwise, references to "us," "we," "our," or "the company" include Mercantile Bank Corporation and its wholly-owned subsidiaries. As a bank holding company, we are subject to regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). We were organized on July 15, 1997, under the laws of the State of Michigan, primarily for the purpose of holding all of the stock of Mercantile Bank of West Michigan ("our bank"), and of such other subsidiaries as we may acquire or establish. Our bank commenced business on December 15, 1997. Mercantile Bank Mortgage Company initiated business in October 2000 as a subsidiary of our bank, and was reorganized as Mercantile Bank Mortgage Company, LLC ("our mortgage company"), on January 1, 2004. On February 7, 2002, Mercantile BIDCO, Inc. ("our BIDCO"), a subsidiary of our bank, was granted a license by the Michigan Office of Financial and Insurance Services to operate as a Michigan Business and Industrial Development Company under the Michigan BIDCO Act of 1986. Mercantile Insurance Center, Inc. ("our insurance company"), a subsidiary of our bank, commenced operations during 2002 to offer insurance products. Mercantile Bank Real Estate Co., L.L.C., ("our real estate company"), a subsidiary of our bank, was organized on July 21, 2003, principally to develop, construct and own a new facility to be constructed in downtown Grand Rapids which will serve as our bank's new main office and Mercantile Bank Corporation's headquarters. Mercantile Bank Capital Trust I ("the Mercantile trust"), a business trust subsidiary, was formed in September 2004 to issue trust preferred securities. To date we have raised capital from our initial public offering of common stock in October 1997, a public offering of common stock in July 1998, three private placements of common stock during 2001, a public offering of common stock in August 2001 and a public offering of common stock in September 2003. In addition, we raised capital through a public offering of $16.0 million of trust preferred securities in 1999, which was refinanced by a $32.0 million private placement of trust preferred securities in 2004. Our expenses have generally been paid using the proceeds of the capital sales and dividends from our bank. Our principal source of future operating funds is expected to be dividends from our bank. We filed an election to become a financial holding company, pursuant to the Bank Holding Company Act, as amended by Title I of the Gramm-Leach-Bliley Act and implementing Federal Reserve Board regulations, which election became effective March 23, 2000. OUR BANK Our bank is a state banking company that operates under the laws of the State of Michigan, pursuant to a charter issued by the Michigan Office of Financial and Insurance Services. Our bank's deposits are insured to the maximum extent permitted by law by the Federal Deposit Insurance Corporation ("FDIC"). Our bank's primary service area is the Kent and Ottawa County areas of West Michigan, which includes the City of Grand Rapids, the second largest city in the State of Michigan. Our bank, through its seven offices, provides commercial and retail banking services primarily to small- to medium-sized businesses based in and around the Grand Rapids and Holland metropolitan areas. These offices consist of a main office located at 216 North Division Avenue, Grand Rapids, Michigan, a combination branch and retail loan center located at 4613 Alpine Avenue, Comstock Park, Michigan, a combination branch and operations center located at 5610 Byron Center Avenue SW, Wyoming, Michigan, branches located at 4860 Broadmoor, Kentwood, Michigan, 3156 Knapp Street NE, Grand Rapids, Michigan, and 880 16th Street, Holland, Michigan and an administration facility located at 5650 Byron Center Avenue SW, Wyoming, Michigan. 2. Our bank makes secured and unsecured commercial, construction, mortgage and consumer loans, and accepts checking, savings and time deposits. Our bank owns six automated teller machines ("ATM") that participate in the MAC, NYCE and PLUS regional network systems, as well as other ATM networks throughout the country. Our bank also enables customers to conduct certain loan and deposit transactions by telephone and personal computer. Courier service is provided to certain commercial customers, and safe deposit facilities are available at all branch locations. Our bank does not have trust powers. In December 2001, our bank entered into a joint brokerage services and marketing agreement with Raymond James Financial Services, Inc. to make available to its customers financial planning, retail brokerage, equity research, insurance and annuities, retirement planning, trust services and estate planning. OUR MORTGAGE COMPANY Our mortgage company's predecessor, Mercantile Bank Mortgage Company, commenced operations on October 24, 2000 when our bank contributed most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans to Mercantile Bank Mortgage Company. On the same date our bank also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company, which is 99% owned by our bank and 1% owned by our insurance company. The reorganization had no impact on the company's financial position or results of operations. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement. OUR BIDCO Our BIDCO was granted a license by the Michigan Office of Financial and Insurance Services on February 7, 2002, to operate our BIDCO as a Michigan Business and Industrial Development Company. Our BIDCO, a non-depository Michigan financial institution, offers equipment lease financing, asset based loans, junior debt facilities and other financing where equity features may be part of the facility pricing. OUR INSURANCE COMPANY Our insurance company acquired an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent. The insurance products are marketed through a central facility operated by the Michigan Bankers Insurance Association, members of which include the insurance subsidiaries of various Michigan-based financial institutions and Hub International. Our insurance company receives commissions based upon written premiums produced under the Agency and Institution Agreement. OUR REAL ESTATE COMPANY Our real estate company was organized on July 21, 2003, principally to develop, construct and own a new facility to be constructed in downtown Grand Rapids which will serve as our bank's new main office and Mercantile Bank Corporation's headquarters. Our real estate company is 99% owned by our bank and 1% owned by our insurance company. 3. THE MERCANTILE TRUST In 2004 we formed the Mercantile trust, a Delaware business trust. Mercantile trust's business and affairs are conducted by its property trustee, a Delaware trust company, and three individual administrative trustees who are employees and officers of the company. Mercantile trust was established for the purpose of issuing and selling its Series A and Series B trust preferred securities and common securities, and used the proceeds from the sales of those securities to acquire Series A and Series B Floating Rate Notes issued by the company. Substantially all of the net proceeds received by the company from the Series A transaction were used to redeem the trust preferred securities that had been issued by MBWM Capital Trust I in September 1999. Substantially all of the net proceeds received by the company from the Series B transaction were contributed to our bank as capital. The Series A and Series B Floating Rate Notes are categorized on our consolidated financial statements as subordinated debentures. Additional information regarding Mercantile trust is incorporated by reference to "Note 15 - Subordinated Debentures" and "Note 17 - Regulatory Matters" of the Consolidated Financial Statements included in this Annual Report on pages F-52 through F-54. EFFECT OF GOVERNMENT MONETARY POLICIES Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government, its agencies, and the Federal Reserve Board. The Federal Reserve Board's monetary policies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation, maintain employment, and mitigate economic recessions. The policies of the Federal Reserve Board have a major effect upon the levels of bank loans, investments and deposits through its open market operations in United States government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. Our bank maintains reserves directly with the Federal Reserve Bank of Chicago to the extent required by law. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies. REGULATION AND SUPERVISION As a bank holding company under the Bank Holding Company Act, we are required to file an annual report with the Federal Reserve Board and such additional information as the Federal Reserve Board may require. We are also subject to examination by the Federal Reserve Board. The Bank Holding Company Act limits the activities of bank holding companies that have not qualified as financial holding companies to banking and the management of banking organizations, and to certain non-banking activities. These non-banking activities include those activities that the Federal Reserve Board found, by order or regulation as of the day prior to enactment of the Gramm-Leach-Bliley Act, to be so closely related to banking as to be a proper incident to banking. These non-banking activities include, among other things: operating a mortgage company, finance company, factoring company; performing certain data processing operations; providing certain investment and financial advice; acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, nonoperating basis; and providing discount securities brokerage services for customers. With the exception of the activities of our mortgage company and our BIDCO discussed above, neither we nor any of our subsidiaries engages in any of the non-banking activities listed above. In March 2000, our election to become a financial holding company, as permitted by the Bank Holding Company Act, as amended by Title I of the Gramm-Leach-Bliley Act, was accepted by the Federal Reserve Board. In order to continue as a financial holding company, we and our bank must satisfy statutory requirements regarding capitalization, management, and compliance with the Community Reinvestment Act. As a financial holding company, we are permitted to engage in a broader range of activities than are permitted to bank holding companies. 4. Those expanded activities include any activity which the Federal Reserve Board (in certain instances in consultation with the Department of the Treasury) determines, by order or regulation, to be financial in nature or incidental to such financial activity, or to be complementary to a financial activity and not to pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Such expanded activities include, among others: insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability or death, or issuing annuities, and acting as principal, agent, or broker for such purposes; providing financial, investment, or economic advisory services, including advising a mutual fund; and underwriting, dealing in, or making a market in securities. Other than the insurance agency activities of our insurance company, neither we nor our subsidiaries presently engage in any of the expanded activities. Our bank is subject to restrictions imposed by federal law and regulation. Among other things, these restrictions apply to any extension of credit to us or to our other subsidiaries, to investments in stock or other securities that we issue, to the taking of such stock or securities as collateral for loans to any borrower, and to acquisitions of assets or services from, and sales of certain types of assets to, us or our other subsidiaries. Federal law prevents us from borrowing from our bank unless the loans are secured in designated amounts with specified forms of collateral. With respect to the acquisition of banking organizations, we are generally required to obtain the prior approval of the Federal Reserve Board before we can acquire all or substantially all of the assets of any bank, or acquire ownership or control of any voting shares of any bank or bank holding company, if, after the acquisition, we would own or control more than 5% of the voting shares of the bank or bank holding company. Acquisitions of banking organizations across state lines are subject to certain restrictions imposed by Federal and state law and regulations. EMPLOYEES As of December 31, 2004, we and our bank employed 164 full-time and 45 part-time persons. Management believes that relations with employees are good. LENDING POLICY As a routine part of our business, we make loans and leases to businesses and individuals located within our market area. Our lending policy states that the function of the lending operation is twofold: to provide a means for the investment of funds at a profitable rate of return with an acceptable degree of risk, and to meet the credit needs of the creditworthy businesses and individuals who are our customers. We recognize that in the normal business of lending, some losses on loans and leases will be inevitable and should be considered a part of the normal cost of doing business. Our lending policy anticipates that priorities in extending loans and leases will be modified from time to time as interest rates, market conditions and competitive factors change. The policy sets forth guidelines on a nondiscriminatory basis for lending in accordance with applicable laws and regulations. The policy describes various criteria for granting loans and leases, including the ability to pay; the character of the customer; evidence of financial responsibility; purpose of the loan or lease; knowledge of collateral and its value; terms of repayment; source of repayment; payment history; and economic conditions. The lending policy further limits the amount of funds that may be loaned or leased against specified types of real estate collateral. For certain loans secured by real estate, the policy requires an appraisal of the property offered as collateral by a state certified independent appraiser. The policy also provides general guidelines for loan to value and lease to value limits for other types of collateral, such as accounts receivable and machinery and equipment. In addition, the policy provides general guidelines as to environmental analysis, loans to employees, executive officers and directors, problem loan and lease identification, maintenance of an allowance for loan and lease losses, loan and lease review and grading, mortgage and consumer lending, and other matters relating to our lending practices. 5. The Board of Directors has delegated significant lending authority to officers of our bank. The Board of Directors believes this empowerment, supported by our strong credit culture and the significant experience of our commercial lending staff, makes us responsive to our customers. The loan policy currently specifies lending authority for certain officers up to $2.0 million, and $7.5 million for our bank's Chairman of the Board and its President and Chief Executive Officer; however, the $7.5 million lending authority is used only in rare circumstances where timing is of the essence. Generally, loan requests exceeding $2.5 million require approval by the Officers Loan Committee, and loan requests exceeding $4.0 million, up to the legal lending limit of approximately $33.6 million, require approval by the Board of Directors. In most circumstances we apply an in-house lending limit that is significantly less than our bank's legal lending limit. LENDING ACTIVITY Commercial Loans. Our commercial lending group originates commercial loans and leases primarily in our market area. Commercial loans and leases are originated by 15 lenders, with almost 220 years of combined commercial lending experience, ten of whom have 15 years or more experience. Loans and leases are originated for general business purposes, including working capital, accounts receivable financing, machinery and equipment acquisition, and commercial real estate financing including new construction and land development. Working capital loans are often structured as a line of credit and are reviewed periodically in connection with the borrower's year-end financial reporting. These loans are generally secured by substantially all of the assets of the borrower, and have an interest rate tied to the national prime rate. Loans and leases for machinery and equipment purposes typically have a maturity of three to five years and are fully amortizing, while commercial real estate loans are usually written with a five-year maturity and amortized over a 15 year period. Commercial loans and leases typically have an interest rate that is fixed to maturity or is tied to the national prime rate. We evaluate many aspects of a commercial loan or lease transaction in order to minimize credit and interest rate risk. Underwriting includes an assessment of the management, products, markets, cash flow, capital, income and collateral. This analysis includes a review of the borrower's historical and projected financial results. Appraisals are generally required by certified independent appraisers where real estate is the primary collateral, and in some cases, where equipment is the primary collateral. In certain situations, for creditworthy customers, we may accept title reports instead of requiring lenders' policies of title insurance. Commercial real estate lending involves more risk than residential lending because loan balances are greater and repayment is dependent upon the borrower's business operations. We attempt to minimize the risks associated with these transactions by generally limiting our commercial real estate lending to owner-operated properties of well-known customers or new customers whose businesses have an established profitable history. In many cases, risk is further reduced by limiting the amount of credit to any one borrower to an amount considerably less than our legal lending limit and avoiding certain types of commercial real estate financings. We have no material foreign loans, and no material loans to energy producing customers. We have only limited exposure to companies engaged in agricultural-related activities. Single-Family Residential Real Estate Loans. Our mortgage company originates single-family residential real estate loans in our market area, usually according to secondary market underwriting standards. Loans not conforming to those standards are made in limited circumstances. Single-family residential real estate loans provide borrowers with a fixed or adjustable interest rate with terms up to 30 years. Our bank has a home equity line of credit program. Home equity credit is generally secured by either a first or second mortgage on the borrower's primary residence. The program provides revolving credit at a rate tied to the national prime rate. 6. Consumer Loans. We originate consumer loans for a variety of personal financial needs, including new and used automobiles, boat loans, credit cards and overdraft protection for our checking account customers. Consumer loans generally have shorter terms and higher interest rates and usually involve more credit risk than single-family residential real estate loans because of the type and nature of the collateral. While we do not utilize a formal credit scoring system, management believes our consumer loans are underwritten carefully, with a strong emphasis on the amount of the down payment, credit quality, employment stability and monthly income of the borrower. These loans are generally repaid on a monthly repayment schedule with the source of repayment tied to the borrower's periodic income. In addition, consumer lending collections are dependent on the borrower's continuing financial stability, and are thus likely to be adversely affected by job loss, illness and personal bankruptcy. In many cases, repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of depreciation of the underlying collateral. Management believes that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans and that consumer loans are important to our efforts to serve the credit needs of the communities and customers that we serve. LOAN AND LEASE PORTFOLIO QUALITY We utilize a comprehensive grading system for our commercial loans and leases as well as residential mortgage and consumer loans. Administered as part of the loan and lease review program, virtually all commercial loans and leases are graded on an eight grade rating system. The rating system utilizes a standardized grade paradigm that analyzes several critical factors such as cash flow, management and collateral coverage. All commercial loans and leases are graded at inception and later at various intervals. Residential mortgage and consumer loans are graded on a four grade rating system using a separate standardized grade paradigm that analyzes several critical factors such as debt-to-income and credit and employment histories. Residential mortgage and consumer loans are generally only graded once after the loans are made. Our independent loan and lease review program is primarily responsible for the administration of the grading system and ensuring adherence to established lending policies and procedures. The loan and lease review program is an integral part of maintaining our strong asset quality culture. The loan and lease review function works closely with senior management, although it functionally reports to the Board of Directors. All commercial loan and lease relationships exceeding $1.0 million are formally reviewed every twelve to eighteen months. Credits between $0.5 million and $1.0 million are formally reviewed every two years, with a random sampling performed on credits under $0.5 million. Our watch list credits are reviewed monthly by our Watch List Committee, which is comprised of personnel from the administration, lending and loan and lease review functions. Loans and leases are placed in a nonaccrual status when, in the opinion of management, uncertainty exists as to the ultimate collection of principal and interest. As of December 31, 2004, loans and leases placed in nonaccrual status totaled $2.8 million, or 0.22% of total loans. As of the same date there were no loans and leases past due 90 days or more and still accruing interest. As of December 31, 2004, there were no other significant loans and leases where known information about credit problems of borrowers warranted the placing of the loans or leases in a nonaccrual status. Management is not aware of any potential problem credits that could have a material adverse effect on our operating results, liquidity, or capital resources. Additional detail and information relative to the loan and lease portfolio is incorporated by reference to Management's Discussion and Analysis of Financial Condition and Results of Operation ("Management's Discussion and Analysis") beginning on Page F-4 and Note 3 of the Consolidated Financial Statements on pages F-42 and F-43 included in this Annual Report. 7. ALLOWANCE FOR LOAN AND LEASE LOSSES In each accounting period, the allowance for loan and lease losses ("allowance") is adjusted by management to the amount management believes is necessary to maintain the allowance at adequate levels. Through its loan and lease review and credit departments, management attempts to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. Management's evaluation of the allowance is further based on, but not limited to, consideration of internally prepared calculations based upon the experience of senior management and lending staff making similar loans and leases in the same community almost 20 years, composition of the loan and lease portfolio, third party analysis of the loan and lease administration processes and portfolio and general economic conditions. In addition, our bank's status as a relatively new banking organization, the rapid loan growth since inception and commercial lending emphasis is taken into account. Management believes that the present allowance is adequate, based on the broad range of considerations listed above. The primary risks associated with commercial loans and leases are the financial condition of the borrower, the sufficiency of collateral, and lack of timely payment. Management has a policy of requesting and reviewing periodic financial statements from its commercial loan and lease customers, and periodically reviews existence of collateral and its value. The primary risk element considered by management with respect to each consumer and residential real estate loan is lack of timely payment. Management has a reporting system that monitors past due loans and has adopted policies to pursue its creditor's rights in order to preserve our bank's collateral position. Additional detail regarding the allowance is incorporated by reference to Management's Discussion and Analysis beginning on Page F-4 and Note 3 of the Consolidated Financial Statements of the Company on pages F-42 and F-43 included in this Annual Report. Although management believes the allowance is adequate to absorb losses as they arise, there can be no assurance that we will not sustain losses in any given period which could be substantial in relation to, or greater than, the size of the allowance. INVESTMENTS Bank Holding Company Investments. The principle investment of our bank holding company are the investments in the common stock of our bank and the common securities of Mercantile trust. Other funds of our bank holding company may be invested from time to time in various debt instruments. As a bank holding company, we are also permitted to make portfolio investments in equity securities and to make equity investments in subsidiaries engaged in a variety of non-banking activities, which include real estate-related activities such as community development, real estate appraisals, arranging equity financing for commercial real estate, and owning and operating real estate used substantially by our bank or acquired for its future use. In addition, our bank holding company's qualification as a financial holding company enables us to make equity investments in companies engaged in a broader range of financial activities than we could do without that qualification. Such expanded activities include insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability or death, or issuing annuities, and acting as principal, agent, or broker for such purposes; providing financial, investment, or economic advisory services, including advising a mutual fund; and underwriting, dealing in, or making a market in securities. Our bank holding company has no plans at this time to make directly any of these equity investments at the bank holding company level. Our Board of Directors may, however, alter the investment policy at any time without shareholder approval. 8. In addition, so long as our bank holding company is qualified as a financial holding company, it would be permitted, as part of the business of underwriting or merchant banking activity and under certain circumstances and procedures, to invest in shares or other ownership interests in, or assets of, companies engaged in non-financial activities. In order to make those investments, our bank holding company would be required (i) to become, or to have an affiliate that is, a registered securities broker or dealer or a registered municipal securities dealer, or (ii) to control both an insurance company engaged in underwriting insurance (other than credit insurance) or issuing annuities, and a registered investment adviser that furnishes investment advice to an insurance company. We do not currently have any securities, insurance, or investment advisory affiliates of the required types, nor does our bank holding company have any current plans to make any of the equity investments described in this paragraph. Our Bank's Investments. Our bank may invest its funds in a wide variety of debt instruments and may participate in the federal funds market with other depository institutions. Subject to certain exceptions, our bank is prohibited from investing in equity securities. Among the equity investments permitted for our bank under various conditions and subject in some instances to amount limitations, are shares of a subsidiary insurance agency, mortgage company, real estate company, or Michigan business and industrial development company, such as our insurance company, our mortgage company, our real estate company, or our BIDCO. Under another such exception, in certain circumstances and with prior notice to or approval of the FDIC, our bank could invest up to 10% of its total assets in the equity securities of a subsidiary corporation engaged in the acquisition and development of real property for sale, or the improvement of real property by construction or rehabilitation of residential or commercial units for sale or lease. Our bank has no present plans to make such an investment. Real estate acquired by our bank in satisfaction of or foreclosure upon loans may be held by our bank. Our bank is also permitted to invest in such real estate as is necessary for the convenient transaction of its business. Our bank's Board of Directors may alter the bank's investment policy without shareholder approval at any time. Additional detail and information relative to the securities portfolio is incorporated by reference to Management's Discussion and Analysis beginning at Page F-4 and Note 2 of the Consolidated Financial Statements on pages F-39 through F-41 included in this Annual Report. COMPETITION Our primary market area for loans and core deposits is Kent and Ottawa Counties of western Michigan, which includes the City of Grand Rapids, the second largest city in the State of Michigan. We face substantial competition in all phases of our operations from a variety of different competitors. We compete for deposits, loans and other financial services with numerous Michigan-based and out-of-state banks, savings banks, thrifts, credit unions and other financial institutions as well as from other entities that provide financial services. Some of the financial institutions and financial service organizations with which we compete are not subject to the same degree of regulation as we are. Many of our primary competitors have been in business for many years, have established customer bases, are larger, have substantially higher lending limits than we do, and offer larger branch networks and other services which we do not. Most of these same entities have greater capital resources than we do, which, among other things, may allow them to price their services at levels more favorable to the customer and to provide larger credit facilities than we do. Under the Gramm-Leach-Bliley Act, effective March 11, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act may significantly change the competitive environment in which we conduct our business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. SELECTED STATISTICAL INFORMATION Management's Discussion and Analysis beginning at Page F-4 in this Annual Report includes selected statistical information. 9. RETURN ON EQUITY AND ASSETS Return on Equity and Asset information is included in Management's Discussion and Analysis beginning at Page F-4 in this Annual Report. AVAILABLE INFORMATION We maintain an internet website at www.mercbank.com. We make available on or through our website, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practical after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We do not intend the address of our website to be an active link or to otherwise incorporate the contents of our website into this Annual Report. ITEM 2. PROPERTIES Our bank leases a one story building in downtown Grand Rapids, Michigan for use as its main office. This building is of masonry construction and has approximately 11,000 square feet of usable space with on-site parking. The lease for this facility, which commenced in 1997, has an initial term of ten years and our bank has four, five-year renewal options. The address of this facility is 216 North Division Avenue, Grand Rapids, Michigan. Our bank designed and constructed a full service branch and retail loan facility in Alpine Township, a northwest suburb of Grand Rapids, which opened in July of 1999. The facility is one story, of masonry construction, and has approximately 8,000 square feet of usable space. The land and building are owned by our bank. The facility has multiple drive-through lanes and ample parking space. The address of this facility is 4613 Alpine Avenue NW, Comstock Park, Michigan. During 2001 our bank designed and constructed two facilities on a 4-acre parcel of land located in the City of Wyoming, a southwest suburb of Grand Rapids. The land had been purchased by our bank in 2000. The larger of the two buildings is a full service branch and operations facility which opened in September of 2001. The facility is two-stories, of masonry construction, and has approximately 25,000 square feet of usable space. The facility is owned by our bank, and has multiple drive-through lanes and ample parking space. The address of this facility is 5610 Byron Center Avenue SW, Wyoming, Michigan. The other building, a single-story facility of masonry construction with approximately 7,000 square feet of usable space, accommodates the company's and bank's administration function. This facility is also owned by the bank. The address of this facility is 5650 Byron Center Avenue SW, Wyoming, Michigan. During 2002 our bank designed and constructed a full service branch in the City of Kentwood, a southeast suburb of Grand Rapids, which opened in December of 2002. The land had been purchased by our bank in 2001. The facility is one story, of masonry construction, and has approximately 10,000 square feet of usable space. The facility is owned by our bank, and has multiple drive-through lanes and ample parking space. The address of this facility is 4860 Broadmoor, Kentwood, Michigan. During 2003 our bank designed and constructed a full service branch in the northeast quadrant of the City of Grand Rapids. The land had been purchased by our bank in 2002. The facility is one story, of masonry construction, and has approximately 3,500 square feet of usable space. The facility is owned by our bank, and has multiple drive-through lanes and ample parking space. The address of this facility is 3156 Knapp Street NE, Grand Rapids, Michigan. 10. During 2003 our bank designed and started construction of a new four-story facility located approximately two miles north from the center of downtown Grand Rapids. This facility will serve as the new location for our bank's current downtown facility located on North Division Avenue, with all existing functions and employees at that location ultimately transferring to this new facility upon completion. Currently, the North Division Avenue facility serves as our bank's main office, and houses our bank's commercial lending and review function, a full service branch, portions of our bank's retail lending and business development function and our bank's brokerage operation. The new facility will also house our bank's loan operations function, which is currently located at our facility on Alpine Avenue NW, as well as the company's and bank's administration function currently located in Wyoming, Michigan. The facility will consist of approximately 55,000 square feet of usable space and contain multiple drive-through lanes with ample parking. The address of this facility is 310 Leonard Street NW, Grand Rapids, Michigan. Completion date for this facility is expected during the second quarter of 2005. During 2003 our bank designed and started construction of a new two-story facility located in Holland, Michigan. This facility, which was completed during the fourth quarter of 2004, serves as a full service banking center for the Holland area, including commercial lending, retail lending and a full service branch. The facility consists of approximately 30,000 square feet of usable space and contains multiple drive-through lanes with ample parking. The address of this facility is 880 East 16th Street, Holland, Michigan. ITEM 3. LEGAL PROCEEDINGS From time to time, we may be involved in various legal proceedings that are incidental to our business. In the opinion of management, we are not a party to any current legal proceedings that are material to our financial condition, either individually or in the aggregate. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is quoted on the Nasdaq National Market under the symbol "MBWM". At February 1, 2005, there were 255 record holders of our common stock. In addition, we estimate that there were approximately 3,000 beneficial owners of our common stock who own their shares through brokers or banks. 11. The following table shows the high and low bid prices for our common stock as reported by the Nasdaq National Market for the periods indicated, and the quarterly cash dividends paid by us during those periods. The prices do not include retail mark-up, mark-down or commission, but have been adjusted for the 5% stock dividends paid on May 3, 2004 and February 3, 2003.
HIGH LOW DIVIDEND ------ ------ -------- 2004 First Quarter ..................................... $38.77 $32.97 $0.09 Second Quarter .................................... 37.28 31.55 0.09 Third Quarter ..................................... 36.05 32.82 0.09 Fourth Quarter .................................... 44.00 34.51 0.09 2003 First Quarter ..................................... $25.32 $20.78 $0.08 Second Quarter .................................... 27.38 22.66 0.08 Third Quarter ..................................... 32.59 26.65 0.08 Fourth Quarter .................................... 35.44 29.97 0.08
Holders of our common stock are entitled to receive dividends that the Board of Directors may declare from time to time. We may only pay dividends out of funds that are legally available for that purpose. We are a holding company and substantially all of our assets are held by our subsidiaries. Our ability to pay dividends to our shareholders depends primarily on our bank's ability to pay dividends to us. Dividend payments and extensions of credit to us from our bank are subject to legal and regulatory limitations, generally based on capital levels and current and retained earnings imposed by law and regulatory agencies with authority over our bank. The ability of our bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. In addition, under the terms of our subordinated debentures, we would be precluded from paying dividends on our common stock if an event of default has occurred and is continuing under the subordinated debentures, or if we exercised our right to defer payments of interest on the subordinated debentures, until the deferral ended. On January 11, 2005, we declared a $0.10 per share cash dividend on our common stock, payable on March 10, 2005 to record holders as of February 10, 2005. We currently expect to continue to pay a quarterly cash dividend, although there can be no assurance that we will continue to do so. On October 12, 2004, we issued 15,000 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 $8.227 per share aggregating $123,405.00. 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 $123,388.40, with the difference paid in cash. Also on October 12, 2004, we issued 1,000 shares of our common stock to another 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 $8.227 per share aggregating $8,227.00. 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 $8,190.67, with the difference paid in cash. On October 13, 2004, we issued 1,000 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 $8.227 per share aggregating $8,227.00. 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 $8,195.01, 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. 12. 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 Per Announced Plans or Purchased Under the Period Purchased Share Programs Plans or Programs - ------ --------- -------------- ------------------- ---------------------- October 1 - 31 3,703 $37.746 0 0 November 1 - 30 0 N/A 0 0 December 1 - 31 0 N/A 0 0 Total 3,703 $37.746 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 6. SELECTED FINANCIAL DATA The Selected Financial Data on page F-3 in this Annual Report is incorporated here by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Management's Discussion and Analysis on pages F-4 through F-25 in this Annual Report is incorporated here by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information under the heading "Market Risk Analysis" on pages F-22 through F-25 in this Annual Report is incorporated here by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Reports of Independent Registered Public Accounting Firm on pages F-26 through F-56 in this Annual Report are incorporated here by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None 13. ITEM 9A. CONTROLS AND PROCEDURES As of December 31, 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 December 31, 2004. There have been no significant changes in our internal controls over financial reporting during the quarter ended December 31, 2004, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004. Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Crowe Chizek and Company LLC, an independent registered public accounting firm, as stated in their report which is included herein. ITEM 9B. OTHER INFORMATION On October 28, 2004, the Board of Directors of our bank approved the bank's non-lender bonus plan for 2005. Under the plan, non-lender officers and other non-lender employees of our bank may receive bonuses for 2005 up to a specified percentage of their annual base salary. For our Chairman and Chief Executive Officer, and our President and Chief Operating Officer, the percentage is 50%. For our Executive Vice President and Secretary, and our Senior Vice President, Chief Financial Officer and Treasurer, the percentage is 45%. It is anticipated that for bonuses under the plan, they will be payable only to the extent that after taking into account all of the payments under the plan, our after tax net operating income for 2005 would equal or exceed 120% of the prior year's after tax net income. A copy of the plan is included as an exhibit to this Annual Report. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information presented under the captions "Information about Directors, Nominees and Executive Officers" and "Section 16(a) Beneficial Ownership Compliance" in the definitive Proxy Statement of Mercantile for its April 28, 2005 Annual Meeting of Shareholders (the "Proxy Statement"), a copy of which will be filed with the Securities and Exchange Commission before the meeting date, is incorporated here by reference. We have a separately-designated standing audit committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of the Audit Committee consist of Betty S. Burton, David M. Cassard, C. John Gill, David M. Hecht Calvin D. Murdock and Merle J. Prins. The Board of Directors has determined that Mr. Cassard, a member of the Audit Committee, is qualified as an audit committee financial expert, as that term is defined in the rules of the Securities and Exchange Commission. Mr. Cassard is independent, as independence for audit committee members is defined in the listing standards of the Nasdaq Stock Market and the rules of the Securities and Exchange Commission. 14. We have adopted a Code of Ethics that applies to all of our directors, officers and employees, including our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. The Code of Ethics is posted on our website (www.mercbank.com). We intend to post amendments to or waivers from our Code of Ethics, of the type referred to in Item 5.05 of Form 8-K, to the extent applicable to our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions, on our website. ITEM 11. EXECUTIVE COMPENSATION The information presented under the captions "Director Compensation," "Compensation Committee Interlocks and Insider Participation," "Summary Compensation Table," "Option Grants in 2004," "Aggregated Stock Option Exercises in 2004 and Year End Option Values" and "Employment Agreements", in the Proxy Statement is incorporated here by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information presented under the caption "Stock Ownership of Certain Beneficial Owners and Management" in the Proxy Statement is incorporated here by reference. The following table summarizes information, as of December 31, 2004, relating to compensation plans under which equity securities are authorized for issuance.
Number of securities remaining available for Number of securities to Weighted average exercise future issuance under be issued upon exercise price of outstanding equity compensation plans of outstanding options, options, warrants and (excluding securities Plan Category warrants and rights rights reflected in column (a)) - ------------- ----------------------- ------------------------- ------------------------- (a) (b) (c) Equity compensation plans approved by security holders (1) 281,822 $19.60 262,994 Equity compensation plans not approved by security holders 0 0 0 Total 281,822 $19.60 262,994
(1) These plans are Mercantile's 1997 Employee Stock Option Plan, 2000 Employee Stock Option Plan, 2004 Employee Stock Option Plan and Independent Director Stock Option Plan. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information presented under the caption "Certain Transactions" in the Proxy Statement is incorporated here by reference. 15. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information presented under the caption "Fees to Independent Auditors for 2004 and 2003" in the Proxy Statement is incorporated here by reference. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements. The following financial statements and reports of independent registered public accounting firm of Mercantile Bank Corporation and its subsidiaries are filed as part of this report: Reports of Independent Registered Public Accounting Firm dated February 26, 2005 Consolidated Balance Sheets --- December 31, 2004 and 2003 Consolidated Statements of Income for each of the three years in the period ended December 31, 2004 Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period ended December 31, 2004 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2004 Notes to Consolidated Financial Statements The financial statements, the notes to financial statements, and the reports of independent registered public accounting firm listed above are incorporated by reference in Item 8 of this report. (2) Financial Statement Schedules Not applicable (b) Exhibits:
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 3.1 Our Articles of Incorporation are incorporated by reference to exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2004 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 10.1 Our 1997 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 * 10.2 Our 2000 Employee Stock Option Plan is incorporated by reference to exhibit 10.14 of our Form 10-K for the year ended December 31, 2000 * 10.3 Our 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 10-Q for the quarter ended September 30, 2004 *
16.
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 10.4 Form of Stock Option Agreement for options under the 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.2 of our Form 10-Q for the quarter ended September 30, 2004 * 10.5 Our Independent Director Stock Option Plan is incorporated by reference to exhibit 10.26 of our Form 10-K for the year ended December 31, 2002 * 10.6 Form of Stock Option Agreement for options under the Independent Director Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 8-K dated October 21, 2004 * 10.7 Nonlender Bonus Plan is incorporated by reference to exhibit 10.3 of our Form 10-Q for the quarter ended September 30, 2004 * 10.8 Mercantile Bank of West Michigan Deferred Compensation Plan for Members of the Board of Directors (1999) is incorporated by reference to Exhibit 10.6 of the Registration Statement of the company and our trust on Form SB-2 (Commission File Nos. 333-84313 and 333-84313-01) that became effective on September 13, 1999 * 10.9 Lease Agreement between our bank and Division Avenue Partners, L.L.C. dated August 16, 1997, is incorporated by reference to exhibit 10.2 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective October 23, 1997 10.10 Agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.3 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 10.11 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated May 12, 2000 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.15 of our Form 10-K for the year ended December 31, 2000 10.12 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated November 22, 2002 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.5 of our Form 10-K for the year ended December 31, 2002 10.13 Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2001 * 10.14 Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2001 * 10.15 Employment Agreement dated as of October 18, 2001, among the company, our bank and Robert B. Kaminski, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 *
17.
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 10.16 Employment Agreement dated as of October 18, 2001, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * 10.17 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2002 * 10.18 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2002 * 10.19 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Robert B. Kaminski, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2002 * 10.20 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.24 of our Form 10-K for the year ended December 31, 2002 * 10.21 Amendment to Employment Agreement dated as of October 28, 2004, among the company, our bank and Robert B. Kaminski * 10.22 Agreement between our bank and Visser Brothers Construction Inc. dated May 8, 2002, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum, is incorporated by reference to exhibit 10.25 of our Form 10-K for the year ended December 31, 2002 10.23 Agreement between our real estate company and Visser Brothers, Inc. dated November 20, 2003, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2003 10.24 Agreement between our bank and Rockford Construction Company, Inc., dated December 3, 2003, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2003 10.25 Junior Subordinated Indenture between us and Wilmington Trust Company dated September 16, 2004 providing for the issuance of the Series A and Series B Floating Rate Junior Subordinated Notes due 2034 is incorporated by reference to exhibit 10.1 of our Form 8-K dated December 15, 2004 10.26 Amended and Restated Trust Agreement dated September 16, 2004 for Mercantile Bank Capital Trust I is incorporated by reference to exhibit 10.2 of our Form 8-K dated December 15, 2004 10.27 Placement Agreement between us, Mercantile Bank Capital Trust I, and SunTrust Capital Markets, Inc. dated September 16, 2004 is incorporated by reference to exhibit 10.3 of our Form 8-K dated December 15, 2004
18.
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 10.28 Guarantee Agreement dated September 16, 2004 between Mercantile as Guarantor and Wilmington Trust Company as Guarantee Trustee is incorporated by reference to exhibit 10.4 of our Form 8-K dated December 15, 2004 21 Subsidiaries of the company 23 Consent of Independent Registered Public Accounting Firm 31 Rule 13a-14(a) Certifications 32.1 Section 1350 Chief Executive Officer Certification 32.2 Section 1350 Chief Financial Officer Certification
* - Management contract or compensatory plan (c) Financial Statements Not Included In Annual Report Not applicable 19. MERCANTILE BANK CORPORATION CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 F-1 MERCANTILE BANK CORPORATION CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003
CONTENTS SELECTED FINANCIAL DATA.................................................. F-3 MANAGEMENT'S DISCUSSION AND ANALYSIS..................................... F-4 REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM................. F-26 REPORT BY MERCANTILE BANK CORPORATION'S MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING...................................... F-28 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS........................................... F-29 CONSOLIDATED STATEMENTS OF INCOME..................................... F-30 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY............ F-31 CONSOLIDATED STATEMENTS OF CASH FLOWS................................. F-33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS............................ F-34
F-2 SELECTED FINANCIAL DATA
2004 2003 2002 2001 2000 ---------- ---------- -------- -------- -------- (In thousands except per share data) CONSOLIDATED RESULTS OF OPERATIONS: Interest income $ 69,022 $ 54,658 $ 47,632 $ 44,619 $ 36,835 Interest expense 26,595 23,395 24,026 28,249 24,608 ---------- ---------- -------- -------- -------- Net interest income 42,427 31,263 23,606 16,370 12,227 Provision for loan and lease losses 4,674 3,800 3,002 2,370 1,854 Noninterest income 4,302 4,409 3,101 1,927 1,240 Noninterest expense 23,198 18,071 12,781 9,454 7,515 ---------- ---------- -------- -------- -------- Income before income tax expense 18,857 13,801 10,924 6,473 4,098 Income tax expense 5,136 3,785 3,167 1,990 1,303 ---------- ---------- -------- -------- -------- Net income $ 13,721 $ 10,016 $ 7,757 $ 4,483 $ 2,795 ========== ========== ======== ======== ======== CONSOLIDATED BALANCE SHEET DATA: Total assets $1,536,119 $1,203,337 $922,360 $699,187 $513,251 Cash and cash equivalents 20,811 16,564 28,117 19,938 18,102 Securities 152,965 121,510 96,893 78,818 60,457 Loans and leases, net of deferred fees 1,317,124 1,035,963 771,554 587,248 429,804 Allowance for loan and lease losses 17,819 14,379 10,890 8,494 6,302 Bank owned life insurance policies 23,750 16,441 14,876 3,991 0 Deposits 1,159,181 902,892 754,113 569,077 425,740 Securities sold under agreements to repurchase 56,317 49,545 50,335 36,485 32,151 Federal Home Loan Bank advances 120,000 90,000 15,000 0 0 Subordinated debentures 32,990 16,495 16,495 16,495 16,495 Shareholders' equity 141,617 130,201 79,834 71,463 31,854 CONSOLIDATED FINANCIAL RATIOS: Return on average assets 0.99% 0.96% 0.97% 0.74% 0.63% Return on average shareholders' equity 10.16% 10.61% 10.30% 9.05% 9.48% Average shareholders' equity to average assets 9.79% 9.00% 9.45% 8.21% 6.63% Nonperforming loans and leases to loans and leases 0.22% 0.17% 0.10% 0.24% 0.02% Allowance for loan and lease losses to loans 1.35% 1.39% 1.41% 1.45% 1.47% Tier 1 leverage capital 11.53% 12.49% 10.72% 13.00% 8.59% Tier 1 leverage risk-based capital 11.82% 12.60% 10.85% 13.00% 8.59% Total risk-based capital 13.03% 13.84% 12.10% 14.25% 10.97% PER SHARE DATA: Net Income: Basic $ 1.91 $ 1.65 $ 1.36 $ 1.05 $ 0.93 Diluted 1.87 1.61 1.34 1.04 0.92 Book value at end of period 19.69 18.17 14.03 12.56 10.55 Dividends declared 0.36 0.32 NA NA NA Dividend payout ratio 18.60% 18.41% NA NA NA
NA - Not Applicable F-3 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS The following discussion and other portions of this Annual Report contain 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. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Management's Discussion and Analysis of financial condition and results of operations are based on Mercantile Bank Corporation's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan and lease losses, and actual results could differ from those estimates. The allowance for loan and lease losses is maintained at a level we believe is adequate to absorb probable losses identified and inherent in the loan and lease portfolio. Our evaluation of the adequacy of the allowance for loan and lease losses is an estimate based on reviews of individual loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance for loan and leases losses represents management's best estimate, but significant downturns in circumstances relating to loan and lease quality or economic conditions could result in a requirement for an increased allowance for loan and lease losses in the near future. Likewise, an upturn in loan and lease quality or improved economic conditions may result in a decline in the required allowance for loan and lease losses. In either instance unanticipated changes could have a significant impact on operating earnings. The allowance for loan and lease losses is increased through a provision charged to operating expense. Uncollectible loans and leases are charged-off through the allowance for loan and lease losses. Recoveries of loans and leases previously charged-off are added to the allowance for loan and lease losses. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. F-4 INTRODUCTION This Management's Discussion and Analysis should be read in conjunction with the consolidated financial statements contained herein. This discussion provides information about the consolidated financial condition and results of operations of Mercantile Bank Corporation and its consolidated subsidiary, Mercantile Bank of West Michigan ("our bank"), and of Mercantile Bank Mortgage Company, LLC ("our mortgage company"), Mercantile BIDCO, Inc. ("our BIDCO"), Mercantile Bank Real Estate Co., L.L.C. ("our real estate company") and Mercantile Insurance Center, Inc. (our insurance company"), subsidiaries of our bank. Unless the text clearly suggests otherwise, references to "us," "we," "our," or "the company" include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above. We were incorporated on July 15, 1997 as a bank holding company to establish and own our bank. Our bank, after receiving all necessary regulatory approvals, began operations on December 15, 1997. Our bank has a strong commitment to community banking and offers a wide range of financial products and services, primarily to small- to medium-sized businesses, as well as individuals. Our bank's lending strategy focuses on commercial lending, and, to a lesser extent, residential mortgage and consumer lending. Our bank also offers a broad array of deposit products, including checking, savings, money market, and certificates of deposit, as well as security repurchase agreements. Our bank's primary market area is the Kent and Ottawa County areas of West Michigan, which includes the City of Grand Rapids, the second largest city in the State of Michigan. Our bank utilizes certificates of deposit from customers located outside of the primary market area to assist in funding the rapid asset growth our bank has experienced since inception. Mercantile Bank Capital Trust I ("the Mercantile trust"), a business trust established by the company, was incorporated in 2004 for the purpose of issuing Series A and Series B Preferred Securities. On September 16, 2004, the Mercantile trust sold the Series A Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series A Common Securities to Mercantile Bank Corporation. The proceeds of the Series A Preferred Securities and the Series A Common Securities were used by the Mercantile trust to purchase $16,495,000 of Series A Floating Rate Notes that were issued by Mercantile Bank Corporation on September 16, 2004. Mercantile Bank Corporation used the proceeds of the Series A Floating Rate Notes to finance the redemption on September 17, 2004 of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. On December 10, 2004, the Mercantile trust sold the Series B Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series B Common Securities to Mercantile Bank Corporation. The proceeds of the Series B Preferred Securities and the Series B Common Securities were used by the Mercantile trust to purchase $16,495,000 of Series B Floating Rate Notes that were issued by Mercantile Bank Corporation on December 10, 2004. Substantially all of the net proceeds of the Series B Floating Rate Notes were contributed to our bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. The only significant assets of the Mercantile trust are the Series A and Series B Floating Rate Notes, and the only significant liabilities of the Mercantile trust are the Series A and Series B Preferred Securities. The Series A and Series B Floating Rate Notes are categorized on the company's consolidated balance sheet as subordinated debentures and the interest expense is recorded on the company's consolidated statement of income under interest expense on long-term borrowings. Our mortgage company's predecessor, Mercantile Bank Mortgage Company, was formed to increase the profitability and efficiency of the company's mortgage loan operations. Mercantile Bank Mortgage Company initiated business on October 24, 2000 from our bank's contribution of most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans. On the same date our bank had also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company. Mortgage loans originated and held by our mortgage company are serviced by our bank pursuant to a servicing agreement. On February 7, 2002 our BIDCO was granted a license by the Michigan Office of Financial and Insurance Services to operate as a Michigan Business and Industrial Development Company. Our BIDCO, a non-depository Michigan financial institution, offers equipment lease financing, asset based loans, junior debt facilities and other financing where equity features may be part of the facility pricing. F-5 Our insurance company acquired, at nominal cost, an existing shelf insurance agency effective April 15, 2002. An Agency and Institution Agreement was entered into among our insurance company, our bank and Hub International for the purpose of providing programs of mass marketed personal lines of insurance. Insurance product offerings include private passenger automobile, homeowners, personal inland marine, boat owners, recreational vehicle, dwelling fire, umbrella policies, small business and life insurance products, all of which are provided by and written through companies that have appointed Hub International as their agent. The insurance products are marketed through a central facility operated by the Michigan Bankers Insurance Association, members of which include the insurance subsidiaries of various Michigan-based financial institutions and Hub International. Our insurance company receives commissions based upon written premiums produced under the Agency and Institution Agreement. Our real estate company was organized on July 21, 2003, principally to develop, construct and own a new facility to be constructed in downtown Grand Rapids which will serve as our bank's new main office and Mercantile Bank Corporation's headquarters. FINANCIAL CONDITION We continued to experience significant asset growth during 2004. Assets increased from $1,203.3 million on December 31, 2003 to $1,536.1 million on December 31, 2004. This represents an increase in total assets of $332.8 million, or 27.7%. The increase in total assets was primarily comprised of a $277.7 million increase in net loans and a $31.5 million increase in securities. The increase in assets was primarily funded by a $256.3 million increase in deposits, a $30.0 million increase in Federal Home Loan Bank advances, a $16.5 million increase in subordinated debentures and a $11.4 million increase in shareholder's equity. EARNING ASSETS Average earning assets equaled 95.3% of average total assets during 2004, compared to 95.2% during 2003. Although we experienced significant asset growth during 2004, the asset composition remained relatively constant. The loan portfolio continued to comprise a majority of earning assets, followed by securities, federal funds sold and short-term investments. Our loan and lease portfolio, which equaled 89.6% of average earnings assets during 2004, is primarily comprised of commercial loans and leases. Constituting 90.3% of average loans and leases and growing by $250.7 million during 2004, the commercial loan and lease portfolio represent loans to businesses generally located within our market area. Approximately 69% of the commercial loan and lease portfolio is primarily secured by real estate properties, with the remaining generally secured by other business assets such as accounts receivable, inventory, and equipment. 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 are consistent with our strategy of focusing a substantial amount of our efforts on "wholesale" banking. Corporate and business lending continues to be an area of expertise for 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 virtually our only source of significant demand deposits. Residential mortgage and consumer lending, while averaging only 9.7% of average loans during 2004, also experienced strong growth; however, while we expect the residential mortgage loan and consumer loan portfolios to increase in future periods, given our wholesale banking strategy, the commercial sector of the lending efforts and resultant assets are expected to remain the dominant loan portfolio category. The following tables present the maturity of total loans outstanding, as of December 31, 2004, according to scheduled repayments of principal on fixed rate loans and repricing frequency on variable rate loans. 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. F-6
0-1 1-5 After 5 Year Years Years Total ------------ ------------ ----------- -------------- Construction and land development $117,910,000 $ 17,898,000 $ 897,000 $ 136,705,000 Real estate - secured by 1-4 family properties 78,370,000 31,274,000 12,991,000 122,635,000 Real estate - secured by multi-family properties 25,725,000 9,458,000 0 35,183,000 Real estate - secured by nonresidential properties 440,121,000 189,044,000 20,250,000 649,415,000 Commercial 321,821,000 40,321,000 3,473,000 365,615,000 Leases 367,000 2,206,000 0 2,573,000 Consumer 1,770,000 3,174,000 54,000 4,998,000 ------------ ------------ ----------- -------------- $986,084,000 $293,375,000 $37,665,000 $1,317,124,000 ============ ============ =========== ============== Fixed rate loans $ 31,489,000 $292,319,000 $37,665,000 $ 361,473,000 Floating rate loans 954,595,000 1,056,000 0 955,651,000 ------------ ------------ ----------- -------------- $986,084,000 $293,375,000 $37,665,000 $1,317,124,000 ============ ============ =========== ==============
Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on the internal "Watch List." Senior management reviews this list regularly. The quality of our loan portfolio remains strong, with past due loans and net loan charge-offs well below banking industry averages during 2004. As of December 31, 2004, past due and nonaccrual loans and leases totaled $2.8 million, or 0.22% of total loans and leases. At December 31, 2003, past due and nonaccrual loans totaled $1.8 million, or 0.17% of total loans. Net loan and lease charge-offs during 2004 totaled $1.2 million, or 0.10% of average total loans and leases. During 2003 net loan and lease charge-offs totaled $311,000, or 0.04% of average total loans and leases. Over 98% of the loan portfolio consists of loans extended directly to companies or individuals doing business and residing within our market area. The remaining portion is comprised of commercial loans participated with certain unaffiliated commercial banks outside the immediate area, which are underwritten using the same loan criteria as though our bank was the originating bank. The following table summarizes nonperforming loans and troubled debt restructurings.
December 31,2004 December 31, 2003 December 31, 2002 December 31, 2001 December 31, 2000 ---------------- ----------------- ----------------- ----------------- ----------------- Loans on nonaccrual status $2,842,000 $ 233,000 $796,000 $382,000 $95,000 Loans 90 days or more past due and accruing interest 0 1,552,000 0 0 0 Troubled debt restructurings 0 0 0 0 0 ---------- ---------- -------- -------- ------- Total $2,842,000 $1,785,000 $796,000 $382,000 $95,000 ========== ========== ======== ======== =======
F-7 The following table summarizes changes in the allowance for loan and lease losses for the past five years.
2004 2003 2002 2001 2000 -------------- -------------- ------------ ------------ ------------ Loan and leases outstanding at year-end $1,317,124,000 $1,035,963,000 $771,554,000 $587,248,000 $429,804,000 ============== ============== ============ ============ ============ Daily average balance of loans and leases outstanding $1,177,568,000 $ 887,512,000 $669,781,000 $500,965,000 $372,428,000 ============== ============== ============ ============ ============ Balance of allowance at beginning of year $ 14,379,000 $ 10,890,000 $ 8,494,000 $ 6,302,000 $ 4,620,000 Loans and leases charged-off: Commercial, financial and agricultural (1,328,000) (471,000) (696,000) (247,000) (147,000) Construction and land development 0 0 0 0 0 Leases 0 0 0 0 0 Residential real estate (16,000) (26,000) 0 (4,000) 0 Instalment loans to individuals (61,000) (99,000) (10,000) (1,000) (38,000) -------------- -------------- ------------ ------------ ------------ Total loans and leases charged-off (1,405,000) (596,000) (706,000) (252,000) (185,000) Recoveries of previously charged-off loans and leases: Commercial, financial and agricultural 150,000 257,000 78,000 73,000 13,000 Construction and land development 0 0 0 0 0 Leases 0 0 0 0 0 Residential real estate 0 78,000 4,000 0 0 Instalment loans to individuals 21,000 6,000 18,000 1,000 0 -------------- -------------- ------------ ------------ ------------ Total recoveries 171,000 285,000 100,000 74,000 13,000 -------------- -------------- ------------ ------------ ------------ Net charge-offs (1,234,000) (311,000) (606,000) (178,000) (172,000) Provision for loan and leases losses 4,674,000 3,800,000 3,002,000 2,370,000 1,854,000 -------------- -------------- ------------ ------------ ------------ Balance of allowance at year-end $ 17,819,000 $ 14,379,000 $ 10,890,000 $ 8,494,000 $ 6,302,000 ============== ============== ============ ============ ============ Ratio of net charge-offs during the period to average loans and leases outstanding during the period (0.10%) (0.04%) (0.09%) (0.04%) (0.05%) ============== ============== ============ ============ ============ Ratio of allowance to loans and leases outstanding at end of the period 1.35% 1.39% 1.41% 1.45% 1.47% ============== ============== ============ ============ ============
In each accounting period the allowance for loan and lease losses ("allowance") is adjusted to the amount believed necessary to maintain the allowance at adequate levels. Through the loan review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance 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 and lease administration processes and portfolio and general economic conditions. In addition, the rapid commercial loan and lease growth is taken into account. The Reserve 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 total loans, reserve allocation factors are based upon the loan ratings as determined by our loan rating paradigm that is administered by our loan review function. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific loan relationships, including impaired loans, are made on a case-by-case basis. The reserve allocation factors are primarily based on the experience of senior management making similar loans in the same community for almost 20 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. F-8 The following table illustrates the breakdown of the allowance balance to loan type (dollars in thousands) and of the total loan and lease portfolio (in percentages).
December 31, 2004 December 31, 2003 December 31, 2002 December 31, 2001 December 31, 2000 ------------------- ------------------- ------------------- ------------------ ------------------ Loan Loan Loan Loan Loan Amount Portfolio Amount Portfolio Amount Portfolio Amount Portfolio Amount Portfolio ------- --------- ------- --------- ------- --------- ------ --------- ------ --------- Commercial, financial and agricultural $15,457 79.8% $12,220 79.0% $ 9,188 77.9% $7,172 81.0% $5,259 81.6% Construction and land development 1,581 10.3 1,571 11.4 1,143 13.5 785 10.7 580 9.0 Leases 39 0.2 26 0.2 11 0.1 0 NA 0 NA Residential real estate 557 9.3 450 8.9 443 7.9 453 7.2 369 7.8 Instalment loans to individuals 185 0.4 112 0.5 105 0.6 84 1.1 94 1.6 Unallocated 0 NA 0 NA 0 NA 0 NA 0 NA ------- ----- ------- ----- ------- ----- ------ ----- ------ ----- Total $17,819 100.0% $14,379 100.0% $10,890 100.0% $8,494 100.0% $6,302 100.0% ======= ===== ======= ===== ======= ===== ====== ===== ====== =====
The primary risk elements with respect to commercial loans and leases are the financial condition of the borrower, the sufficiency of collateral, and lack of timely payment. We have a policy of requesting and reviewing periodic financial statements from commercial loan and lease customers, and we periodically review the existence of collateral and its value. The primary risk element with respect to each installment and residential real estate loan is lack of timely payment. We have a reporting system that monitors past due loans and have adopted policies to pursue creditor's rights in order to preserve our bank's position. Although we believe that the allowance is adequate to sustain losses as they arise, there can be no assurance that our bank will not sustain losses in any given period that could be substantial in relation to, or greater than, the size of the allowance. The securities portfolio also experienced significant growth during 2004, increasing from $121.5 million on December 31, 2003 to $153.0 million at December 31, 2004. During 2004, the securities portfolio equaled 9.9% of average earning assets. We maintain the portfolio at levels to provide adequate pledging for the repurchase agreement program and secondary liquidity for our daily operations. In addition, the portfolio serves a primary interest rate risk management function. At December 31, 2004, the portfolio was comprised of high credit quality U.S. Government Agency issued bonds (37%), municipal general obligation and revenue bonds (34%), U.S. Government Agency issued and guaranteed mortgage-backed securities (25%) and Federal Home Loan Bank stock (4%). F-9 The following table reflects the composition of the securities portfolio.
December 31, 2004 December 31, 2003 December 31, 2002 ------------------------- ------------------------- ------------------------ Carrying Carrying Carrying Value Percentage Value Percentage Value Percentage ------------ ---------- ------------ ---------- ----------- ---------- U.S. Government agency debt obligations $ 56,025,000 38.3% $ 34,078,000 29.2% $16,338,000 17.0% Mortgage-backed securities 37,801,000 25.9 37,343,000 32.1 43,276,000 45.0 Municipal general obligations 45,063,000 30.8 38,594,000 33.1 29,578,000 30.8 Municipal revenue bonds 7,278,000 5.0 6,518,000 5.6 6,915,000 7.2 ------------ ----- ------------ ----- ----------- ----- Total $146,167,000 100.0% $116,533,000 100.0% $96,107,000 100.0%
All securities, with the exception of tax-exempt municipal bonds, have been designated as "available for sale" as defined in Financial Accounting Standards Board Standard (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Securities designated as available for sale are stated at fair value, with the unrealized gains and losses, net of income tax, reported as a separate component of shareholders' equity in accumulated other comprehensive income. The fair value of securities designated as available for sale at December 31, 2004 and 2003 was $93.8 million and $71.4 million, respectively. The net unrealized gain recorded at December 31, 2004 and 2003, was $0.2 million and $0.3 million, respectively. All tax-exempt municipal bonds have been designated as "held to maturity" as defined in SFAS No. 115, and are stated at amortized cost. As of December 31, 2004 and 2003, held to maturity securities had an amortized cost of $52.3 million and $45.1 million and a fair value of $54.6 million and $47.1 million, respectively. The following table shows by class of maturities as of December 31, 2004, the amounts and weighted average yields of investment securities (1):
Carrying Average Value Yield ------------ ------- (Dollars in thousands) U.S. Treasury securities and obligations of U.S. Government agencies and corporations One year or less $ 0 NA Over one through five years 0 NA Over five through ten years 56,025,000 5.04% Over ten years 0 NA ------------ ---- 56,025,000 5.04 Obligations of states and political subdivisions One year or less 906,000 6.89 Over one through five years 4,947,000 6.88 Over five through ten years 9,771,000 6.79 Over ten years 36,717,000 6.67 ------------ ---- 52,341,000 6.72 Mortgage-backed securities 37,801,000 4.75 ------------ ---- $146,167,000 5.57% ============ ====
(1) Yields on tax-exempt securities are computed on a fully taxable-equivalent basis. F-10 Federal funds sold, consisting of excess funds sold overnight to correspondent banks, are used to manage daily liquidity needs and interest rate sensitivity. During 2004, the average balance of these funds equaled 0.5% of average earning assets. This level is well within our internal policy guidelines and is not expected to change significantly in the near future. Cash and cash equivalents increased from $16.6 million at December 31, 2003, to $20.8 million on December 31, 2004, an increase of $4.2 million. The increase was primarily the result of larger amounts of deposits made by our deposit customers on the last day of 2004 when compared to the last day of 2003. Our commercial lending and wholesale funding focus results in relatively large day-to-day fluctuations of our cash and cash equivalent balances; however, relative to our asset size the balances are generally stable. Cash and cash equivalent balances averaged $38.1 million, or 2.8% of average assets during 2004, compared to $28.7 million, or 2.7% of average assets, during 2003. Net premises and equipment increased from $15.3 million at December 31, 2003, to $24.6 million on December 31, 2004, an increase of $9.3 million. The increase primarily reflects the land purchase and construction costs associated with our new banking facility in Holland, and the land purchase and initial construction costs associated with our planned new main office in downtown Grand Rapids. SOURCE OF FUNDS Our major source of funds is from deposits and Federal Home Loan Bank ("FHLB") advances. Total deposits increased from $902.9 million at December 31, 2003, to $1,159.2 million on December 31, 2004, an increase of $256.3 million, or 28.4%. Included within these numbers is the success we achieved in generating deposit growth from customers located within the market area during 2004. Local deposits increased from $311.3 million at December 31, 2003, to $388.0 million on December 31, 2004, an increase of $76.7 million, or 24.7%. Despite this success in obtaining funds from local customers, the substantial asset growth has necessitated the continued acquisition of funds from depositors outside of the market area and FHLB advances. Out-of-area deposits increased from $591.6 million at December 31, 2003, to $771.2 million on December 31, 2004, an increase of $179.6 million, or 30.3%. FHLB advances increased from $90.0 million at December 31, 2003, to $120.0 million on December 31, 2004, an increase of $30.0 million. At December 31, 2004, local deposits and securities sold under agreements to repurchase ("repurchase agreements") equaled 32.9% of funding liabilities, compared to 34.4% on December 31, 2003. During 2004 we experienced significant growth in our check-writing deposit accounts, which include noninterest-bearing demand accounts, interest-bearing checking accounts and money market deposit accounts. In aggregate these deposit types grew $30.8 million, or 25.9%. Leading the growth was noninterest-bearing demand accounts. Comprised primarily of business loan customers, noninterest-bearing demand accounts grew $25.2 million, or 32.9%, and equaled 7.3% of average total liabilities during 2004. Interest-bearing checking accounts increased $3.4 million, or 10.0%, and equaled 2.7% of average total liabilities during 2004. Money market deposit accounts increased $2.2 million, or 27.0%, and equaled 0.7% of average total liabilities during 2004. Business loan customers also comprise the majority of interest-bearing checking and money market deposit accounts, although to a lesser extent than noninterest-bearing checking accounts. Pursuant to Federal law and regulations, incorporated businesses may not own interest-bearing checking accounts and transactions from money market accounts are limited. We anticipate continued growth of our check-writing deposit accounts as additional business loans are extended and through the efforts of our branch network and business development activities. During 2004, savings account balances recorded an increase of $27.7 million, or 27.2%, and equaled 10.9% of average total liabilities. Business loan customers also comprise the majority of savings account holders, although to a lesser extent than check-writing accounts. We anticipate an increase in savings account balances as additional business loans are extended and through the efforts of our branch network and business development activities. F-11 Certificates of deposit purchased by customers located within the market area increased during 2004, growing from $90.5 million at December 31, 2003, to $108.7 million on December 31, 2004, a growth rate of 20.2%. These deposits accounted for 7.7% of average total liabilities during 2004. The growth was primarily attributable to individuals and municipalities. The increase in local municipality certificates of deposit has been facilitated by our qualifying for funds from new municipal customers and additional funds from existing customers through a combination of our asset growth and increased profitability as measured by the municipalities' investment policy guidelines, and is a trend that we expect to continue. During 2004, certificates of deposit obtained from customers located outside of the market area increased by $179.5 million, and represented 55.0% of average total liabilities during 2004. At December 31, 2004, out-of-area deposits totaled $771.2 million. Out-of-area deposits consist primarily of certificates of deposit placed by deposit brokers for a fee, but also include certificates of deposit obtained from the deposit owners directly. The owners of the out-of-area deposits include individuals, businesses and governmental units located throughout the country. 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 most of 2004 rates paid on new out-of-area deposits were very similar to rates paid on new certificates of deposit issued to local customers. In addition, the overhead costs associated with the out-of-area deposits are considerably less than the overhead costs that would be incurred to administer a similar level of local deposits. Although local deposits have and are expected to increase as new business, governmental and consumer deposit relationships are established and as existing customers increase the balances in their deposit accounts, the relatively high reliance on out-of-area deposits will likely remain. Repurchase agreements increased $6.8 million and equaled 4.0% of average total liabilities during 2004. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts are invested in overnight 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 an interest-bearing checking deposit account. FHLB advances increased $30.0 million and equaled 9.1% of average total liabilities during 2004. FHLB 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 at December 31, 2004 totaled $193.5 million. We first started to use FHLB advances in late 2002, and expect to continue to use this funding source, along with out-of-area certificates of deposit, as part of our wholesale funding program. Subordinated debentures increased $16.5 million and equaled 1.4% of average total liabilities during 2004. In September of 2004 we refinanced our then existing $16.5 million in subordinated debentures by issuing a new subordinated debenture in an equal dollar amount. In December of 2004 we issued an additional $16.5 million in subordinated debentures, with substantially all of the net proceeds contributed to our bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. Shareholders' equity increased $11.4 million and equaled 9.8% of average assets during 2004. The increase was primarily attributable to net income from operations. Net income from operations totaled $13.7 million during 2004. Negatively impacting shareholders' equity during 2004 was the payment of cash dividends, which totaled $2.6 million. F-12 RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 SUMMARY We recorded strong earnings performance during 2004. Net income was $13.7 million, or $1.91 per basic share and $1.87 per diluted share. This earnings performance compares favorably to net income of $10.0 million, or $1.65 per basic share and $1.61 per diluted share, recorded in 2003. The $3.7 million improvement in net income represents an increase of 37.0%, while diluted earnings per share were up 16.1%, with the difference primarily reflecting the impact of our common stock sale during 2003 and resulting increases in average common shares outstanding during 2004. The earnings improvement during 2004 over that of 2003 is primarily attributable to increased net interest income and improved operating efficiencies resulting from asset growth, strong credit culture and controlled overhead expenses. We expect our percentage rate of loan growth to exceed the banking industry average in 2005. Net income for 2004 includes an $845,000 ($548,000 after-tax) write-off associated with the unamortized balance of issuance costs related to the redemption of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. Excluding this one-time expense, net income for 2004 was $14.3 million ($1.99 per basic share and $1.94 per diluted share), which represents a 42.5% increase over net income of $10.0 million ($1.65 per basic share and $1.61 per diluted share) recorded during 2003. We believe excluding the impact of the one-time charge from 2004 operating results and performance measures allows a more meaningful comparison of 2004 results to 2003 results; therefore, the following discussion of our results of operations for the years ended December 31, 2004 and December 31, 2003 includes both GAAP and non-GAAP facts and figures where appropriate. The following table shows some of the key performance and equity ratios for the years ended December 31, 2004 and 2003.
2004 2003 ----- ----- Return on average total assets 0.99% 0.97% Return on average equity 10.16 10.61 Dividend payout ratio 18.58 18.42 Average equity to average assets 9.79 9.00
NET INTEREST INCOME Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $70.0 million and $26.6 million during 2004, respectively, providing for net interest income of $43.4 million. This performance compares favorably to that of 2003 when interest income and interest expense were $55.5 million and $23.4 million, respectively, providing for net interest income of $32.1 million. In comparing 2004 with 2003, interest income increased 26.2%, interest expense was up 13.7% and net interest income increased 35.3%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate risk, common stock sales, liquidity, and customer behavior also impact net interest income as well as the net interest margin. The net interest margin improved from 3.21% in 2003 to 3.30% in 2004, an increase of 2.8%. The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders' equity during 2004, 2003 and 2002 (dollars in thousands). The table also depicts the dollar amount of change in interest income and interest expense of interest-earning assets and interest-bearing liabilities, segregated between change due to volume and change due to rate. For tax-exempt investment 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 $957,000, $808,000 and $611,000 in 2004, 2003 and 2002, respectively. F-13
Years ended December 31, ------------------------------------------------------------------------------------------------- 2004 2003 2002 ------------------------------- ------------------------------- ----------------------------- Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate ---------- -------- ------- ---------- -------- ------- -------- -------- ------- Taxable securities $ 82,107 $ 3,935 4.79% $ 64,957 $ 2,978 4.58% $ 53,509 $ 3,023 5.65% Tax-exempt securities 48,322 3,174 6.57 40,695 2,730 6.71 29,956 2,056 6.86 ---------- -------- ---------- ------- -------- ------- ---- Total securities 130,429 7,109 5.45 105,652 5,708 5.40 83,465 5,079 6.09 Loans and leases 1,177,568 62,791 5.33 887,512 49,700 5.60 669,781 43,032 6.42 Short-term investments 593 4 0.67 369 1 0.27 194 2 1.03 Federal funds sold 5,942 75 1.26 5,083 57 1.12 7,901 130 1.65 ---------- -------- ---------- ------- -------- ------- Total earning assets 1,314,532 69,979 5.32 998,616 55,466 5.55 761,341 48,243 6.34 Allowance for loan and lease losses (16,203) (12,471) (9,620) Cash and due from banks 31,587 23,285 18,568 Other non-earning assets 49,262 39,767 27,377 ---------- ---------- -------- Total assets $1,379,178 $1,049,197 $797,666 ========== ========== ======== Interest-bearing demand deposits $ 32,994 $ 427 1.29% $ 28,406 $ 353 1.24% $ 22,354 $ 399 1.78% Savings deposits 136,214 2,497 1.83 82,754 1,446 1.75 58,679 1,381 2.35 Money market accounts 8,788 129 1.47 8,488 111 1.31 6,870 127 1.85 Time deposits 780,867 18,733 2.40 652,200 18,197 2.79 518,271 19,561 3.77 ---------- ------- ---------- ------- -------- ------- Total interest- bearing deposits 958,863 21,786 2.27 771,848 20,107 2.61 606,174 21,468 3.54 Short-term borrowings 55,816 877 1.57 49,480 712 1.44 44,395 899 2.03 Federal Home Loan Bank advances 112,869 2,471 2.19 46,630 921 1.98 1,014 20 1.97 Long-term borrowings 18,938 1,461 7.71 17,394 1,655 9.51 16,936 1,639 9.68 ---------- -------- ---------- ------- -------- ------- Total interest- bearing liabilities 1,146,486 26,595 2.32 885,352 23,395 2.64 668,519 24,026 3.59 -------- ------- ------- Demand deposits 90,534 63,150 48,140 Other liabilities 7,156 6,329 5,702 ---------- ---------- -------- Total liabilities 1,244,176 954,831 722,361 Average equity 135,002 94,366 75,305 ---------- ---------- -------- Total liabilities and equity $1,379,178 $1,049,197 $797,666 ========== ========== ======== Net interest income $ 43,384 $32,071 $24,217 ======== ======= ======= Rate spread 3.00% 2.91% 2.75% ==== ==== ==== Net interest margin 3.30% 3.21% 3.18% ==== ==== ====
F-14
Years ended December 31, --------------------------------------------------------------------------------- 2004 over 2003 2003 over 2002 --------------------------------------- --------------------------------------- Total Volume Rate Total Volume Rate ----------- ----------- ----------- ----------- ----------- ----------- Increase (decrease) in interest income Taxable securities $ 957,000 $ 817,000 $ 140,000 $ (45,000) $ 582,000 $ (627,000) Tax exempt securities 444,000 502,000 (58,000) 674,000 721,000 (47,000) Loans 13,091,000 15,566,000 (2,475,000) 6,668,000 12,701,000 (6,033,000) Short term investments 3,000 1,000 2,000 (1,000) 1,000 (2,000) Federal funds sold 18,000 10,000 8,000 (73,000) (38,000) (35,000) ----------- ----------- ----------- ----------- ----------- ----------- Net change in tax-equivalent income 14,513,000 16,896,000 (2,383,000) 7,223,000 13,967,000 (6,744,000) Increase (decrease) in interest expense Interest-bearing demand deposits 74,000 59,000 15,000 (46,000) 93,000 (139,000) Savings deposits 1,051,000 977,000 74,000 66,000 477,000 (411,000) Money market accounts 18,000 4,000 14,000 (16,000) 26,000 (42,000) Time deposits 536,000 3,296,000 (2,760,000) (1,365,000) 4,399,000 (5,764,000) Short term borrowings 165,000 96,000 69,000 (187,000) 94,000 (281,000) Federal Home Loan Bank advances 1,550,000 1,440,000 110,000 901,000 901,000 0 Long term borrowings (194,000) 138,000 (332,000) 16,000 44,000 (28,000) ----------- ----------- ----------- ----------- ----------- ----------- Net change in interest expense 3,200,000 6,010,000 (2,810,000) (631,000) 6,034,000 (6,665,000) ----------- ----------- ----------- ----------- ----------- ----------- Net change in tax-equivalent net interest income $11,313,000 $10,886,000 $ 427,000 $ 7,854,000 $ 7,933,000 $ (79,000) =========== =========== =========== =========== =========== ===========
Interest income is primarily generated from the loan portfolio, and to a lesser degree from securities, federal funds sold and short term investments. Interest income increased $14.5 million during 2004 from that earned in 2003, totaling $70.0 million in 2004 compared to $55.5 million in the previous year. The increase is primarily due to the growth in earning assets, which more than offset the impact of a lower interest rate environment during 2004 when compared to 2003. Reflecting the lower interest rates, the yield on average earning assets decreased from 5.55% recorded in 2003 to 5.32% in 2004. The growth in interest income is primarily attributable to an increase in earning assets. During 2004, earning assets averaged $1,314.5 million, a level substantially higher than the average earning assets of $998.6 million during 2003. Growth in average total loans and leases, totaling $290.1 million, comprised 91.8% of the increase in average earnings assets during 2004. Interest income generated from the loan and lease portfolio increased $13.1 million during 2004 over the level earned in 2003, comprised of an increase of $15.6 million from the growth in the loan and lease portfolio which was partially offset by a decrease of $2.5 million due to the decline in the yield earned on the loan portfolio to 5.33% from 5.60%. The decline in the loan and lease portfolio yield is primarily due to lower market interest rates during 2004 than in 2003, and a higher percentage of loans and leases at the lower floating rate pricing arrangement versus a higher fixed interest rate arrangement. Growth in the securities portfolio, combined with a slight increase in yield, also added to the increase in interest income during 2004 over that of 2003. Average securities increased by $24.7 million in 2004, increasing from $105.7 million in 2003 to $130.4 million in 2004. The growth equated to an increase in interest income of $1.3 million, while an increase in the yield earned on the securities portfolio from 5.40% to 5.45% added an additional $0.1 million to interest income. Interest income earned on federal funds sold increased by $18,000 due to a $0.9 million increase in the average balance and a slightly higher yield during 2004. F-15 Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree repurchase agreements, FHLB advances and subordinated debentures. Interest expense increased $3.2 million during 2004 from that paid in 2003, totaling $26.6 million in 2004 compared to $23.4 million in the previous year. The increase in interest expense is primarily attributable to the impact of an increase in interest-bearing liabilities during 2004, which was only partially offset by a lower interest rate environment during 2004 when compared to 2003. Interest-bearing liabilities averaged $1,146.5 million during 2004, a level substantially higher than the average interest-bearing liabilities of $885.4 million during 2003. This growth resulted in increased interest expense of $6.0 million. A decrease in interest expense of $2.8 million was recorded during 2004 due to lower interest rates on certificates of deposit and subordinated debentures, which more than offset the impact of higher interest rates on all other interest-bearing liabilities. The cost of average interest-bearing liabilities decreased from the 2.64% recorded in 2003 to 2.32% in 2004. Growth in average certificates of deposits, totaling $128.7 million, comprised 49.3% of the increase in average interest-bearing liabilities between 2004 and 2003. Average FHLB advances increased $66.2 million, or 25.4% of the increase in average interest-bearing liabilities. The certificate of deposit growth during 2004 equated to an increase in interest expense of $3.3 million; however, a decrease in interest expense of $2.8 million was recorded due to the decline in the average rate paid as higher-rate certificates of deposit matured and were either renewed or replaced with lower-costing certificates of deposit during most of 2004. FHLB advance growth during 2004 equated to an increase in interest expense of $1.4 million, with an increased average rate adding an additional $0.1 million to interest expense. Growth in average savings deposits, totaling $53.5 million, equated to an increase in interest expense of $1.0 million, with an additional interest expense of $0.1 million recorded due to an increase in the average rate paid during 2004. Growth in average interest-bearing checking accounts and money market accounts, totaling a combined $4.9 million, equated to an increase in interest expense of $0.1 million, with only a nominal amount of additional interest expense recorded due to a slightly higher average rate paid during 2004. Average short term borrowings, comprised of repurchase agreements and federal funds purchased, increased $6.3 million during 2004, resulting in increased interest expense of $0.1 million, with an additional interest expense of $0.1 million recorded due to an increase in the average rate paid during 2004. Growth of $1.5 million in average long-term borrowings, comprised primarily of subordinated debentures but also including deferred director and officer compensation programs, equated to an increase in interest expense of $0.1 million during 2004; however, a decline in the average rate paid on subordinated debentures resulting from the September 2004 refinance, equated to a $0.3 million reduction of interest expense during 2004. PROVISION FOR LOAN AND LEASE LOSSES Primarily reflecting continued loan and lease growth, combined with an increase in net loan and leases losses, the provision for loan and lease losses totaled $4.7 million during 2004, compared to the $3.8 million expensed during 2003. The allowance as a percentage of total loans outstanding as of December 31, 2004 was 1.35%, compared to 1.39% at year-end 2003. Loan and lease growth during 2004 equaled $281.2 million, compared to loan and lease growth of $264.4 million during 2003. Net loan and lease charge-offs during 2004 totaled $1.2 million, or 0.10% of average total loans and leases. Net loan and lease charge-offs during 2003 totaled $0.3 million, or 0.04% of average total loans and leases. In each accounting period the allowance for loan and lease losses ("allowance") is adjusted to the amount believed necessary to maintain the allowance at adequate levels. Through the loan review and credit departments, we attempt to allocate specific portions of the allowance based on specifically identifiable problem loans and leases. The evaluation of the allowance 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 and lease administration processes and portfolio and general economic conditions. In addition, the rapid commercial loan and lease growth is taken into account. F-16 The Reserve 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 total loans, reserve allocation factors are based upon the loan ratings as determined by our loan rating paradigm that is administered by our loan review function. For retail loans, reserve allocation factors are based upon the type of credit. Adjustments for specific loan relationships, including impaired loans, are made on a case-by-case basis. The reserve allocation factors are primarily based on the experience of senior management making similar loans in the same community for almost 20 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 Noninterest income totaled $4.3 million in 2004, a slight decline from the $4.4 million earned in 2003. Increased fee income on virtually all non-mortgage-related products and services was just shy of offsetting a large decline in residential mortgage-related fee income. Deposit and repurchase agreement service charges increased $0.1 million in 2004 from the amount earned in 2003, primarily reflecting the growth in the number of deposit accounts and modest increases in the deposit fee structure which was partially offset by a lower deposit earnings credit rate during 2004. Fees on commercial letters of credit increased during 2004 when compared to 2003, although the increase generally reflects the change in recognizing the fees that occurred in early 2003 whereby fees had to be recognized into income over the life of the letter of credit instead of immediately upon issuing the letter of credit, rather than an increase in the level of letters of credit outstanding. Reflecting a decrease in volume of refinance activity resulting from a higher interest rate environment, fees earned on referring residential mortgage loan applicants to various third parties totaled $0.4 million in 2004, down from the $1.0 million earned in 2003. Aggregate net gains on the sale of loans and securities during 2004 virtually equaled the level of net gains on the sale of loans and securities during 2003. NONINTEREST EXPENSE Noninterest expense during 2004 totaled $23.2 million, an increase of 28.4% over the $18.1 million expensed in 2003. Of the $5.1 million growth in overhead costs, $2.6 million (51.0%) was in salaries and benefits, and primarily reflects the increase in full-time equivalent employees from 161 at year-end 2003 to 194 at year-end 2004 and annual pay increases. Occupancy, furniture and equipment costs increased $0.3 million (11.9%) in 2004 over that expensed in 2003, primarily reflecting the opening of our Holland banking office in October of 2004 and our increased staffing level. Noninterest expense during 2004 includes an $845,000 write-off associated with the unamortized balance of issuance costs related to the redemption of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by the MBWM trust. Excluding this one-time write-off, noninterest expense during 2004 totaled $22.4 million, an increase of 23.7% over the $18.1 million expensed in 2003. While the dollar volume of noninterest costs has increased, the growth of net interest income and fee income has increased by a much higher degree. Noninterest costs during 2004 were $5.1 million higher than the level of overhead costs expensed during 2003; however, net interest income and fee income increased a combined $11.1 million during the same time period. Monitoring and controlling our noninterest costs, while at the same time providing high quality service to our customers, is one of our priorities. The efficiency ratio, a banking industry standardized calculation that attempts to reflect the utilization of overhead costs, reflected improvement during 2004 and remained well below banking industry averages. Computed by dividing noninterest expenses by net interest income plus noninterest income, the efficiency ratio was 49.6% during 2004, compared to 50.7% during 2003. If the one-time write-off addressed above is excluded from the calculation, our 2004 efficiency ratio improves to 47.8%. FEDERAL INCOME TAX EXPENSE Federal income tax expense was $5.1 million in 2004, an increase of $1.4 million, or 35.7% over the $3.8 million expensed during 2003. The increase is primarily due to the growth in our pre-federal income tax profitability. Our effective tax rate in 2004 was 27.2%, compared to 27.4% in 2003. F-17 RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2003 AND 2002 SUMMARY We recorded strong earnings performance during 2003. Net income was $10.0 million, or $1.65 per basic share and $1.61 per diluted share. This earnings performance compares very favorably to net income of $7.8 million, or $1.36 per basic share and $1.34 per diluted share, recorded in 2002. The $2.2 million improvement in net income represents an increase of 29.1%, while diluted earnings per share were up 20.1%, with the difference primarily reflecting the impact of our common stock sale during 2003 and resulting increases in average common shares outstanding. The earnings improvement during 2003 over that of 2002 is primarily attributable to increased net interest income and improved operating efficiencies resulting from asset growth, strong credit culture, controlled overhead expenses and increased fee income. The following table shows some of the key performance and equity ratios for the years ended December 31, 2003 and 2002.
2003 2002 ----- ----- Return on average total assets 0.96% 0.97% Return on average equity 10.61 10.30 Dividend payout ratio 18.42 NA Average equity to average assets 9.00 9.45
NET INTEREST INCOME Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $55.5 million and $23.4 million during 2003, respectively, providing for net interest income of $32.1 million. This performance compares favorably to that of 2002 when interest income and interest expense were $48.2 million and $24.0 million, respectively, providing for net interest income of $24.2 million. In comparing 2003 with 2002, interest income increased 15.0%, interest expense was down 2.6% and net interest income increased 32.4%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate risk, common stock sales, liquidity, and customer behavior also impact net interest income as well as the net interest margin. The net interest margin improved slightly from 3.18% in 2002 to 3.21% in 2003, an increase of 0.9%. Interest income is primarily generated from the loan portfolio, and to a lesser degree from securities, federal funds sold and short term investments. Interest income increased $7.3 million during 2003 from that earned in 2002, totaling $55.5 million in 2003 compared to $48.2 million in the previous year. The increase is due to the growth in earning assets, which more than offset the impact of a lower interest rate environment in 2003. Reflecting the lower interest rates, the yield on average earning assets decreased from 6.34% recorded in 2002 to 5.55% in 2003. The growth in interest income is attributable to an increase in earning assets. During 2003, earning assets averaged $998.6 million, a level substantially higher than the average earning assets of $761.3 million during 2002. Growth in average total loans and leases, totaling $217.7 million, comprised 91.7% of the increase in average earnings assets. Interest income generated from the loan and lease portfolio increased $6.7 million during 2003 over the level earned in 2002, comprised of an increase of $12.7 million from the growth in the loan and lease portfolio which was partially offset by a decrease of $6.0 million due to the decline in the yield earned on the loan portfolio to 5.60% from 6.42%. The decline in the loan and lease portfolio yield is primarily due to lower market interest rates during 2003 and a higher percentage of loans and leases at the lower floating rate pricing arrangement versus a higher fixed interest rate arrangement. F-18 Growth in the securities portfolio also added to the increase in interest income during 2003 over that of 2002. Average securities increased by $22.2 million in 2003, increasing from $83.5 million in 2002 to $105.7 million in 2003. The growth equated to an increase in interest income of $1.3 million, which was partially offset by a decrease of $0.7 million due to the decline in the yield earned on the securities portfolio to 5.40% from 6.09%. Interest income earned on federal funds sold decreased by $73,000 due to a $2.8 million decrease in the average balance and a lower yield during 2003. The lower yield on securities and federal funds sold is primarily the result of lower market interest rates during 2003. Interest expense is primarily generated from interest-bearing deposits, and to a lesser degree repurchase agreements, FHLB advances and subordinated debentures. Interest expense decreased $0.6 million during 2003 from that paid in 2002, totaling $23.4 million in 2003 compared to $24.0 million in the previous year. The decline in interest expense is primarily attributable to the impact of a lower interest rate environment during 2003, which more than offset the impact of the increase in interest-bearing liabilities during 2003. Interest-bearing liabilities averaged $885.4 million during 2003, a level substantially higher than the average interest-bearing liabilities of $668.5 million during 2002. This growth resulted in increased interest expense of $6.0 million; however, a decrease in interest expense of $6.6 million was recorded during 2003 due to lower market interest rates on all interest-bearing liability categories except FHLB advances and subordinated debentures. The cost of average interest-bearing liabilities decreased from the 3.59% recorded in 2002 to 2.64% in 2003. Growth in average certificates of deposits, totaling $133.9 million, comprised 61.7% of the increase in average interest-bearing liabilities between 2003 and 2002. Average FHLB advances increased $45.6 million, or 21.0% of the increase in average interest-bearing liabilities. The certificate of deposit growth during 2003 equated to an increase in interest expense of $4.4 million; however, a decrease in interest expense of $5.8 million was recorded due to the decline in the average rate paid as higher-rate certificates of deposit matured and were either renewed or replaced with lower-costing certificates of deposit. FHLB advance growth during 2003 equated to an increase in interest expense of $0.9 million, with the average interest rate remaining virtually unchanged. Growth in average savings deposits, totaling $24.1 million, equated to an increase in interest expense of $0.5 million, while a decrease in interest expense of $0.4 million was recorded due to the decline in the average rate paid during 2003. Growth in average interest-bearing checking accounts and money market accounts, totaling $7.7 million, equated to an increase in interest expense of $0.1 million, while a decrease in interest expense of $0.2 million was recorded due to the decline in the average rate paid during 2003. Average short term borrowings, comprised of repurchase agreements and federal funds purchased, increased $5.1 million during 2003, resulting in increased interest expense of $0.1 million; however, a decrease of $0.3 million in interest expense was recorded due to the decline in the average rate paid. PROVISION FOR LOAN AND LEASE LOSSES Primarily reflecting continued significant loan and lease growth, the provision for loan and lease losses totaled $3.8 million during 2003, compared to the $3.0 million expensed during 2002. The allowance as a percentage of total loans outstanding as of December 31, 2003 was 1.39%, compared to 1.41% at year-end 2002. Loan and lease growth during 2003 equaled $264.4 million, compared to net loan and lease growth of $184.3 million during 2002. Net loan and lease charge-offs during 2003 totaled $0.3 million, or 0.04% of average total loans and leases. Net loan and lease charge-offs during 2002 totaled $0.6 million, or 0.09% of average total loans and leases. NONINTEREST INCOME Noninterest income totaled $4.4 million in 2003, an increase of 42.2% over the $3.1 million earned in 2002. Deposit and repurchase agreement service charges totaled $1.2 million in 2003, an increase of $0.2 million, or 28.7%, from the amount earned in 2002. The increase is primarily due to the growth in the number of deposit accounts, reduction of the deposit earnings credit rate and modest increases in the deposit fee structure. Reflecting increased volume of refinance activity resulting from the lower interest rate environment, fees earned on referring residential mortgage loan applicants to various third parties totaled $1.0 million in 2003, up from the $0.5 million earned in 2002. Noninterest income related to the cash surrender value of bank owned life insurance policies ("BOLI") totaled $0.8 million in 2003, up from the $0.4 million recorded in 2002. The increase is primarily due to the additional $10.5 million BOLI purchase in August 2002 and the impact of having a full twelve month accrual during 2003. F-19 In addition to providing interest income and secondary liquidity, our securities portfolio plays an integral role in managing our net interest margin. During 2003 we consummated several bond swap transactions, resulting in a net gain on the sales of securities of $321,000. We also consummated several bond swap transactions during 2002, resulting in a net gain on the sales of securities of $270,000. All of the bond swap transactions during 2003 and 2002 were consummated in reaction to declining interest rate environments occurring at the respective time periods of the sales, and against the backdrop of an expected increasing interest rate environment over the next one to four years. During 2003, we sold 25 mortgage-backed securities with an aggregate par value of $15.2 million, while in 2002 we sold 18 mortgage-backed securities with an aggregate par value of $13.5 million. Proceeds from the bond sales were reinvested into mortgage-backed securities containing different underlying interest rate risk characteristics than were contained within the mortgage-backed securities that were sold. NONINTEREST EXPENSE Noninterest expense during 2003 totaled $18.1 million, an increase of 41.4% over the $12.8 million expensed in 2002. Of the $5.3 million growth in overhead costs, $3.6 million (67.9%) was in salaries and benefits, and primarily reflects the increase in full-time equivalent employees from 117 at year-end 2002 to 161 at year-end 2003, annual pay increases and an increase in the maximum dollar amount paid in the company-wide non-lender bonus program. Occupancy, furniture and equipment costs increased $0.6 million (31.7%) in 2003 over that expensed in 2002, primarily reflecting the opening of our Kentwood branch in December 2002, our Knapps Corner branch and retail loan production office in Holland, Michigan in May 2003. The remaining growth in overhead costs were generally due to general and administrative cost increases associated with an increased asset base. While the dollar volume of noninterest costs has increased, the growth of net interest income and fee income has increased by a much higher degree. Noninterest costs during 2003 were $5.3 million higher than the level of overhead costs expensed during 2002; however, net interest income and fee income increased a combined $9.0 million during the same time period. Monitoring and controlling our noninterest costs, while at the same time providing high quality service to our customers, is one of our priorities. The efficiency ratio, a banking industry standardized calculation that attempts to reflect the utilization of overhead costs, reflected slight deterioration during 2003 but remained well below banking industry averages. Computed by dividing noninterest expenses by net interest income plus noninterest income, the efficiency ratio was 50.7% during 2003, compared to 47.9% during 2002. The deterioration is primarily due to the increase in staff and the opening of the three offices noted above. FEDERAL INCOME TAX EXPENSE Federal income tax expense was $3.8 million in 2003, an increase of $0.6 million, or 19.5% over the $3.2 million expensed during 2002. The increase is primarily due to the growth in our pre-federal income tax profitability, which was only partially offset by a decline in our effective federal income tax rate from 29.0% in 2002 to 27.4% in 2003. CAPITAL RESOURCES Shareholders' equity is a noninterest-bearing source of funds that provides support for our asset growth. Shareholders' equity was $141.6 million and $130.2 million at December 31, 2004 and 2003, respectively. The $11.4 million increase during 2004 is primarily attributable to net income from operations. Net income from operations totaled $13.7 million during 2004. Negatively impacting shareholders' equity during 2004 was the payment of cash dividends, which totaled $2.6 million. We and our bank are subject to regulatory capital requirements administered by the State of Michigan and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Our and our bank's capital ratios as of December 31, 2004 and 2003 are disclosed under Note 17 on pages F-52 through F-54 of the Notes to Consolidated Financial Statements. Our ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. On April 7, 2004, we declared a 5% common stock dividend, payable on May 3, 2004 to record holders as of April 16, 2004. This represented the fourth straight year we had declared and paid a 5% stock dividend. Also, during 2004 we declared and paid a $0.09 per common share cash dividend in each calendar quarter, totaling $2.6 million. On January 11, 2005, we declared a $0.10 per common share cash dividend that will be paid on March 10, 2005 to shareholders of record on February 10, 2005. F-20 LIQUIDITY Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans and operate our company. Liquidity is primarily achieved through the growth of deposits (both local and out-of-area) and liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity. Our liquidity strategy is to fund loan growth with deposits, repurchase agreements and other borrowed funds and to maintain an adequate level of short- and medium-term investments to meet typical daily loan and deposit activity. Although net deposit and repurchase agreement growth from depositors located in the market area increased by $83.5 million, or 23.1%, during 2004, the growth was not sufficient to meet the substantial loan growth of $281.2 million and provide monies for additional investing activities. To assist in providing the additional needed funds we regularly obtained certificates of deposit from customers outside of the market area. As of December 31, 2004, out-of-area deposits totaled $771.2 million, or 63.4% of combined deposits and repurchase agreements, an increase in dollar volume from the $591.6 million outstanding, and an increase from the 62.1% level of combined deposits and repurchase agreements, as of December 31, 2003. As a member of the Federal Home Loan Bank of Indianapolis, our bank has access to the FHLB advance borrowing programs. As of December 31, 2004, advances totaled $120.0 million, compared to $90.0 million outstanding as of December 31, 2003. Our borrowing line of credit at December 31, 2004 totaled $193.5 million, with availability of approximately $65.0 million. We have the ability to borrow money on a daily basis through correspondent banks using established federal funds purchased lines. During 2004, our federal funds purchased position averaged $5.9 million, compared to an average federal funds sold position of $5.9 million. At December 31, 2004, our established unsecured federal funds purchased lines totaled $50.0 million. The following table reflects, as of December 31, 2004, significant fixed and determinable contractual obligations to third parties by payment date.
One to Three Three to Five Over Five One Year or Less Years Years Years Total ---------------- ------------ ------------- ----------- ------------ Deposits without a stated maturity $220,820,000 $ 0 $ 0 $ 0 $220,820,000 Certificates of deposits 609,055,000 231,123,000 39,710,000 0 879,888,000 Short term borrowings 71,317,000 0 0 0 71,317,000 Federal Home Loan Bank advances 65,000,000 55,000,000 0 0 120,000,000 Subordinated debentures 0 0 0 32,990,000 32,990,000 Other borrowed money 0 0 0 1,609,000 1,609,000
In addition to normal loan funding and deposit flow, we also need to maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. At December 31, 2004, we had a total of $320.8 million in unfunded loan commitments and $56.5 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $265.4 million were commitments available as lines of credit to be drawn at any time as customers' cash needs vary, and $55.4 million were for loan commitments scheduled to close and become funded within the next three months. We monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management. F-21 The following table depicts our loan commitments at the end of the past three years.
December 31, 2004 December 31, 2003 December 31, 2002 ----------------- ----------------- ----------------- Commercial unused lines of credit $226,935,000 $176,943,000 $131,161,000 Unused lines of credit secured by 1-4 family residential properties 24,988,000 19,020,000 12,381,000 Credit card unused lines of credit 8,307,000 8,990,000 5,824,000 Other consumer unused lines of credit 5,155,000 5,569,000 4,415,000 Commitments to make loans 55,440,000 73,570,000 24,267,000 Standby letters of credit 56,464,000 57,918,000 39,338,000 ------------ ------------ ------------ Total $377,289,000 $342,010,000 $217,386,000
MARKET RISK ANALYSIS 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 interest-earning assets over the interest paid on 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 the net interest margin during periods of changing market interest rates. F-22 The following table depicts our GAP position as of December 31, 2004 (dollars in thousands).
Within Three to One to After Three Twelve Five Five Months Months Years Years Total -------- --------- -------- -------- ---------- Assets: Commercial loans (1) $884,981 $ 20,595 $256,722 $ 24,620 $1,186,918 Leases 335 32 2,206 2,573 Residential real estate loans 76,084 2,286 31,274 12,991 122,635 Consumer loans 1,578 192 3,174 54 4,998 Securities (2) 6,798 1,134 20,547 124,486 152,965 Short term investments 149 149 Allowance for loan and lease losses (17,819) (17,819) Other assets 83,700 83,700 -------- --------- -------- -------- ---------- Total assets 969,925 24,239 313,923 228,032 1,536,119 Liabilities: Interest-bearing checking 37,649 37,649 Savings 129,374 129,374 Money market accounts 10,528 10,528 Time deposits under $100,000 27,688 33,846 38,258 99,792 Time deposits $100,000 and over 181,526 365,994 232,576 780,096 Short term borrowings 71,317 71,317 Federal Home Loan Bank advances 25,000 50,000 45,000 120,000 Long term borrowings 34,599 34,599 Noninterest-bearing checking 101,742 101,742 Other liabilities 9,405 9,405 -------- --------- -------- -------- ---------- Total liabilities 517,681 449,840 315,834 111,147 1,394,502 Shareholders' equity 141,617 141,617 -------- --------- -------- -------- ---------- Total sources of funds 517,681 449,840 315,834 252,764 1,536,119 -------- --------- -------- -------- ---------- Net asset (liability) GAP $452,244 $(425,601) $ (1,911) $(24,732) ======== ========= ======== ======== Cumulative GAP $452,244 $ 26,643 $ 24,732 ======== ========= ======== Percent of cumulative GAP to total assets 29.4% 1.7% 1.6% ======== ========= ========
(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 expected maturities based upon prepayment trends as of December 31, 2004. F-23 The following table depicts our GAP position as of December 31, 2003 (dollars in thousands).
Within Three to One to After Three Twelve Five Five Months Months Years Years Total -------- --------- -------- -------- ---------- Assets: Commercial loans (1) $415,721 $ 23,811 $443,925 $ 53,022 $ 936,479 Leases 2,309 2,309 Residential real estate loans 45,884 3,160 33,040 10,255 92,339 Consumer loans 1,577 253 2,938 68 4,836 Securities (2) 6,073 3,048 24,197 88,192 121,510 Short term investments 255 255 Allowance for loan and lease losses (14,379) (14,379) Other assets 59,483 59,483 -------- --------- -------- -------- ---------- Total assets 469,510 30,272 506,409 196,641 1,202,832 Liabilities: Interest-bearing checking 34,241 34,241 Savings 101,710 101,710 Money market accounts 8,290 8,290 Time deposits under $100,000 20,802 57,888 27,552 106,242 Time deposits $100,000 and over 123,040 288,719 164,071 575,830 Short term borrowings 55,545 55,545 Federal Home Loan Bank advances 10,000 35,000 45,000 90,000 Long term borrowings 1,114 16,000 17,114 Noninterest-bearing checking 76,579 76,579 Other liabilities 7,080 7,080 -------- --------- -------- -------- ---------- Total liabilities 354,742 381,607 236,623 99,659 1,072,631 Shareholders' equity 130,201 130,201 -------- --------- -------- -------- ---------- Total sources of funds 354,742 381,607 236,623 229,860 1,202,832 -------- --------- -------- -------- ---------- Net asset (liability) GAP $114,768 $(351,335) $269,786 $(33,219) ======== ========= ======== ======== Cumulative GAP $114,768 $(236,567) $ 33,219 ======== ========= ======== Percent of cumulative GAP to total assets 9.5% (19.7)% 2.8% ======== ========= ========
(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 expected maturities based upon prepayment trends as of December 31, 2003. The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors. F-24 We conducted multiple simulations as of December 31, 2004, in which it was assumed that changes in market interest rates occurred ranging from up 300 basis points to down 300 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested impact on 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 $(3,649,000) (8.3)% Interest rates down 100 basis points (2,057,000) (4.7) No change in interest rates (719,000) (1.6) Interest rates up 100 basis points 1,179,000 2.7 Interest rates up 200 basis points 3,071,000 7.0
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. F-25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Mercantile Bank Corporation Wyoming, Michigan We have audited the accompanying consolidated balance sheets of Mercantile Bank Corporation as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of Mercantile's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercantile Bank Corporation as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Mercantile Bank Corporation's internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 24, 2005 expressed an unqualified opinion thereon. /s/ Crowe Chizek and Company LLC ---------------------------------------- Crowe Chizek and Company LLC Grand Rapids, Michigan February 24, 2005 F-26 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Mercantile Bank Corporation Wyoming, Michigan We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Mercantile Bank Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercantile Bank Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit We conducted our audit in accordance with the standards of the Public Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that Mercantile Bank Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Mercantile Bank Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Mercantile Bank Corporation and our report dated February 24, 2005 expressed an unqualified opinion on those consolidated financial statements. /s/ Crowe Chizek and Company LLC ---------------------------------------- Crowe Chizek and Company LLC Grand Rapids, Michigan February 24, 2005 F-27 February 24, 2005 REPORT BY MERCANTILE BANK CORPORATION'S MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining an effective system of internal control over financial reporting presented in conformity with generally accepted accounting principles. The system contains monitoring mechanisms, and actions are taken to correct deficiencies identified. There are inherent limitations in the effectiveness of any system of internal control. Accordingly, even an effective system of internal control can provide only reasonable assurance with respect to financial statement preparation. Management assessed the Company's systems of internal control over financial reporting presented in conformity with generally accepted principles as of December 31, 2004. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2004, Mercantile Bank Corporation maintained effective control over financial reporting presented in conformity with generally accepted accounting principles based on those criteria. The Company's independent auditors have issued an audit report on our assessment of the Company's internal control over financial reporting. Mercantile Bank Corporation /s/ Gerald R. Johnson, Jr. - ----------------------------------------------- Gerald R. Johnson, Jr. Chairman and Chief Executive Officer /s/ Charles E. Christmas - ----------------------------------------------- Charles E. Christmas Senior Vice President - Chief Financial Officer F-28 MERCANTILE BANK CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 2004 and 2003
2004 2003 -------------- -------------- ASSETS Cash and due from banks $ 20,662,000 $ 16,309,000 Short term investments 149,000 255,000 -------------- -------------- Total cash and cash equivalents 20,811,000 16,564,000 Securities available for sale 93,826,000 71,421,000 Securities held to maturity (fair value of $54,621,000 at December 31, 2004 and $47,102,000 at December 31, 2003) 52,341,000 45,112,000 Federal Home Loan Bank stock 6,798,000 4,977,000 Total loans and leases 1,317,124,000 1,035,963,000 Allowance for loan and lease losses (17,819,000) (14,379,000) -------------- -------------- Total loans and leases, net 1,299,305,000 1,021,584,000 Premises and equipment, net 24,572,000 15,305,000 Bank owned life insurance policies 23,750,000 16,441,000 Accrued interest receivable 5,644,000 4,098,000 Other assets 9,072,000 7,835,000 -------------- -------------- Total assets $1,536,119,000 $1,203,337,000 ============== ============== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Noninterest-bearing $ 101,742,000 $ 76,579,000 Interest-bearing 1,057,439,000 826,313,000 -------------- -------------- Total 1,159,181,000 902,892,000 Securities sold under agreements to repurchase 56,317,000 49,545,000 Federal funds purchased 15,000,000 6,000,000 Federal Home Loan Bank advances 120,000,000 90,000,000 Subordinated debentures 32,990,000 16,495,000 Other borrowed money 1,609,000 1,114,000 Accrued expenses and other liabilities 9,405,000 7,090,000 -------------- -------------- Total liabilities 1,394,502,000 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; 20,000,000 shares authorized; 7,192,461 and 6,805,914 shares issued and outstanding at December 31, 2004 and 2003 131,010,000 118,560,000 Retained earnings 10,475,000 11,421,000 Accumulated other comprehensive income 132,000 220,000 -------------- -------------- Total shareholders' equity 141,617,000 130,201,000 -------------- -------------- Total liabilities and shareholders' equity $1,536,119,000 $1,203,337,000 ============== ==============
See accompanying notes to consolidated financial statements. F-29 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 2004, 2003 and 2002
2004 2003 2002 ----------- ----------- ----------- Interest income Loans and leases, including fees $62,791,000 $49,700,000 $43,032,000 Securities, taxable 3,935,000 2,978,000 3,023,000 Securities, tax-exempt 2,217,000 1,922,000 1,445,000 Federal funds sold 75,000 57,000 130,000 Short-term investments 4,000 1,000 2,000 ----------- ----------- ----------- Total interest income 69,022,000 54,658,000 47,632,000 Interest expense Deposits 21,786,000 20,107,000 21,468,000 Short-term borrowings 877,000 712,000 899,000 Federal Home Loan Bank advances 2,471,000 921,000 20,000 Long-term borrowings 1,461,000 1,655,000 1,639,000 ----------- ----------- ----------- Total interest expense 26,595,000 23,395,000 24,026,000 ----------- ----------- ----------- NET INTEREST INCOME 42,427,000 31,263,000 23,606,000 Provision for loan and lease losses 4,674,000 3,800,000 3,002,000 ----------- ----------- ----------- NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES 37,753,000 27,463,000 20,604,000 Noninterest income Service charges on accounts 1,255,000 1,178,000 915,000 Increase in cash surrender value of bank owned life insurance policies 735,000 780,000 409,000 Letter of credit fees 450,000 189,000 307,000 Mortgage loan referral fees 440,000 987,000 534,000 Gain on sale of loans 225,000 0 0 Gain on sale of securities 78,000 321,000 270,000 Other income 1,119,000 954,000 666,000 ----------- ----------- ----------- Total noninterest income 4,302,000 4,409,000 3,101,000 Noninterest expense Salaries and benefits 13,956,000 11,371,000 7,771,000 Occupancy 1,588,000 1,386,000 1,069,000 Furniture and equipment 1,093,000 1,009,000 749,000 Data processing 880,000 822,000 571,000 Advertising 465,000 325,000 300,000 Other expense 5,216,000 3,158,000 2,321,000 ----------- ----------- ----------- Total noninterest expenses 23,198,000 18,071,000 12,781,000 ----------- ----------- ----------- INCOME BEFORE FEDERAL INCOME TAX EXPENSE 18,857,000 13,801,000 10,924,000 Federal income tax expense 5,136,000 3,785,000 3,167,000 ----------- ----------- ----------- NET INCOME $13,721,000 $10,016,000 $ 7,757,000 =========== =========== =========== Earnings per share: Basic $ 1.91 $ 1.65 $ 1.36 =========== =========== =========== Diluted $ 1.87 $ 1.61 $ 1.34 =========== =========== ===========
See accompanying notes to consolidated financial statements. F-30 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended December 31, 2004, 2003 and 2002
Accumulated Other Total Common Retained Comprehensive Shareholders' Stock Earnings Income/(Loss) Equity ------------ ----------- ----------------- ------------- BALANCES, JANUARY 1, 2002 $ 69,406,000 $ 1,649,000 $ 408,000 $ 71,463,000 Payment of 5% stock dividend 6,155,000 (6,156,000) (1,000) Issuance costs associated with 2001 stock sale (37,000) (37,000) Stock option exercises, 606 shares 6,000 6,000 Comprehensive income: Net income 7,757,000 7,757,000 Change in net unrealized gain on securities available for sale, net of reclassifications and tax effect 646,000 646,000 ------------ Total comprehensive income 8,403,000 ------------ ----------- ---------- ------------ BALANCES, DECEMBER 31, 2002 75,530,000 3,250,000 1,054,000 79,834,000 Sale of common stock, net of issuance costs, 1,443,336 shares 42,818,000 42,818,000 Employee stock purchase plan, 1,974 shares 57,000 57,000 Dividend reinvestment plan, 3,884 shares 119,000 119,000 Stock option exercises, 31,912 shares 301,000 301,000 Stock tendered for stock option exercises, 10,892 shares (265,000) (265,000) Cash dividends ($0.32 per share) (1,845,000) (1,845,000) Comprehensive income: Net income 10,016,000 10,016,000 Change in net unrealized gain on securities available for sale, net of reclassifications and tax effect (834,000) (834,000) ------------ Total comprehensive income 9,182,000 ------------ ----------- ---------- ------------ BALANCES, DECEMBER 31, 2003 118,560,000 11,421,000 220,000 130,201,000
See accompanying notes to consolidated financial statements. F-31 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Continued) Years ended December 31, 2004, 2003 and 2002
Accumulated Other Total Common Retained Comprehensive Shareholders' Stock Earnings Income/(Loss) Equity ------------ ------------ ----------------- ------------- BALANCES, DECEMBER 31, 2003 118,560,000 11,421,000 220,000 130,201,000 Payment of 5% stock dividend 12,111,000 (12,115,000) (4,000) Employee stock purchase plan, 2,167 shares 79,000 79,000 Dividend reinvestment plan, 3,406 shares 123,000 123,000 Stock option exercises, 51,726 shares 524,000 524,000 Stock tendered for stock option exercises, 10,938 shares (387,000) (387,000) Cash dividends ($0.36 per share) (2,552,000) (2,552,000) Comprehensive income: Net income 13,721,000 13,721,000 Change in net unrealized gain on securities available for sale, net of reclassifications and tax effect (88,000) (88,000) ------------ Total comprehensive income 13,633,000 ------------ ------------ -------- ------------ BALANCES, DECEMBER 31, 2004 $131,010,000 $ 10,475,000 $132,000 $141,617,000 ============ ============ ======== ============
See accompanying notes to consolidated financial statements. F-32 MERCANTILE BANK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2004, 2003 and 2002
2004 2003 2002 ------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 13,721,000 $ 10,016,000 $ 7,757,000 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 1,699,000 1,948,000 1,366,000 Provision for loan and lease losses 4,674,000 3,800,000 3,002,000 Gain on sale of loans (225,000) 0 0 Gain on sale of securities (78,000) (321,000) (270,000) Net change in Accrued interest receivable (1,546,000) (762,000) (525,000) Bank owned life insurance policies (735,000) (780,000) (409,000) Other assets (1,478,000) (1,377,000) (1,484,000) Accrued expenses and other liabilities 2,315,000 1,083,000 579,000 ------------- ------------- ------------- Net cash from operating activities 18,347,000 13,607,000 10,016,000 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of: Securities available for sale (54,718,000) (58,388,000) (41,074,000) Securities held to maturity (8,521,000) (10,126,000) (11,783,000) Federal Home Loan Bank stock (1,821,000) (4,191,000) (1,000) Proceeds from: Sales of securities available for sale 1,748,000 15,983,000 13,997,000 Maturities, calls and repayments of securities available for sale 30,382,000 29,153,000 20,493,000 Maturities, calls and repayments of securities held to maturity 1,256,000 1,495,000 1,255,000 Loan originations and payments, net (282,170,000) (264,720,000) (184,912,000) Purchases of premises and equipment, net (10,516,000) (4,293,000) (3,527,000) Purchases of bank owned life insurance policies (6,574,000) (785,000) (10,476,000) ------------- ------------- ------------- Net cash from investing activities (330,934,000) (295,872,000) (216,028,000) CASH FLOWS FROM FINANCING ACTIVITIES Net increase in deposits 256,289,000 148,779,000 185,036,000 Net increase/(decrease) in securities sold under agreements to repurchase 6,772,000 (790,000) 13,850,000 Proceeds from Federal Home Loan Bank advances 75,000,000 95,000,000 15,000,000 Pay-off of Federal Home Loan Bank advances (45,000,000) (20,000,000) 0 Proceeds from issuance of subordinated debentures 32,990,000 0 0 Pay-off of subordinated debentures (16,495,000) 0 0 Net increase in other borrowed money 9,495,000 6,538,000 337,000 Net proceeds from sale of common stock 0 42,818,000 (37,000) Cash paid in lieu of fractional shares on stock dividend (4,000) 0 (1,000) Employee stock purchase plan 79,000 57,000 0 Dividend reinvestment plan 123,000 119,000 0 Stock option exercises, net 137,000 36,000 6,000 Cash dividends (2,552,000) (1,845,000) 0 ------------- ------------- ------------- Net cash from financing activities 316,834,000 270,712,000 214,191,000 ------------- ------------- ------------- Net change in cash and cash equivalents 4,247,000 (11,553,000) 8,179,000 Cash and cash equivalents at beginning of period 16,564,000 28,117,000 19,938,000 ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 20,811,000 $ 16,564,000 $ 28,117,000 ============= ============= ============= Supplemental disclosures of cash flow information Cash paid during the year for Interest $ 25,107,000 $ 23,261,000 $ 23,883,000 Federal income tax 6,125,000 4,985,000 4,165,000
See accompanying notes to consolidated financial statements. F-33 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Mercantile Bank Corporation ("Mercantile") and its subsidiary, Mercantile Bank of West Michigan ("Bank"), and of Mercantile Bank Mortgage Company, LLC ("Mortgage Company"), Mercantile BIDCO, Inc. ("Mercantile BIDCO"), Mercantile Bank Real Estate Co., L.L.C. ("Mercantile Real Estate") and Mercantile Insurance Center, Inc. ("Mercantile Insurance"), subsidiaries of our bank, after elimination of significant intercompany transactions and accounts. Mercantile Bank Capital Trust I ("Mercantile Trust"), a business trust formed by the company, was incorporated in 2004 for the purpose of issuing Series A and Series B Preferred Securities. On September 16, 2004, the Mercantile Trust sold the Series A Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series A Common Securities to Mercantile. The proceeds of the Series A Preferred Securities and the Series A Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series A Floating Rate Notes that were issued by Mercantile on September 16, 2004. Mercantile used the proceeds of the Series A Floating Rate Notes to finance the redemption on September 17, 2004 of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. On December 10, 2004, Mercantile Trust sold the Series B Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series B Common Securities to Mercantile. The proceeds of the Series B Preferred Securities and the Series B Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series B Floating Rate Notes that were issued by Mercantile on December 10, 2004. Substantially all of the net proceeds of the Series B Floating Rate Notes were contributed to the Bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. The only significant assets of Mercantile Trust are the Series A and Series B Floating Rate Notes, and the only significant liabilities of Mercantile Trust are the Series A and Series B Preferred Securities. The Series A and Series B Floating Rate Notes are categorized on the company's consolidated balance sheet as subordinated debentures and the interest expense is recorded on the company's consolidated statement of income under interest expense on long-term borrowings. Nature of Operations: Mercantile was incorporated on July 15, 1997 to establish and own the Bank based in Grand Rapids, Michigan. The Bank is a community-based financial institution. The Bank began operations on December 15, 1997. The Bank's primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are commercial loans, commercial leases, residential mortgage loans, and installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, real estate and consumer assets. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Real estate loans are secured by both commercial and residential real estate. The Bank's loan accounts are primarily with customers located in western Michigan, within Kent County and Ottawa County. The Bank's retail deposits are also from customers located in western Michigan. As an alternative source of funds, the Bank has also issued certificates to depositors outside of the Bank's primary market area. Substantially all revenues are derived from banking products and services and investment securities. Mercantile Trust was formed during 2004. All of the common securities of this special purpose trust are owned by Mercantile. Mercantile Trust exists solely to issue capital securities. (Continued) F-34 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Mercantile Bank Mortgage Company was formed during 2000. A subsidiary of the Bank, Mercantile Bank Mortgage Company had been established to increase the profitability and efficiency of the mortgage loan operations. Mercantile Bank Mortgage Company initiated business on October 24, 2000 via the Bank's contribution of most of its residential mortgage loan portfolio and participation interests in certain commercial mortgage loans. On the same date the Bank also transferred its residential mortgage origination function to Mercantile Bank Mortgage Company. On January 1, 2004, Mercantile Bank Mortgage Company was reorganized as Mercantile Bank Mortgage Company, LLC, a limited liability company, which is 99% owned by the Bank and 1% owned by Mercantile Insurance. Mortgage loans originated and held by the Mercantile Bank Mortgage Company are serviced by the Bank pursuant to a servicing agreement. On February 7, 2002, Mercantile BIDCO, a wholly-owned subsidiary of the Bank, was granted a license by the Michigan Office of Financial and Insurance Services to operate as a Michigan Business and Industrial Development Company, a non-depository Michigan financial institution. Mercantile BIDCO offers equipment lease financing, asset based loans, junior debt facilities and other financing where equity features may be part of the facility pricing. Mercantile Insurance was formed during 2002 through the acquisition of an existing shelf insurance agency. Insurance products are offered through an Agency and Institutions Agreement among Mercantile Insurance, the Bank and Hub International. The insurance products are marketed through a central facility operated by the Michigan Bankers Insurance Association, members of which include the insurance subsidiaries of various Michigan-based financial institutions and Hub International. Mercantile Insurance receives commissions based upon written premiums produced under the Agency and Institutions Agreement. Mercantile Real Estate was organized on July 21, 2003, principally to develop, construct, and own a new facility to be constructed in downtown Grand Rapids which will serve as our bank's new main office and Mercantile's new headquarters. Mercantile filed an election to become a financial holding company pursuant to Title I of the Gramm-Leach-Bliley Act and implementing Federal Reserve Board regulations effective March 23, 2000. Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan and lease losses and the fair values of financial instruments are particularly subject to change. Cash Flow Reporting: Cash and cash equivalents include cash on hand, demand deposits with other financial institutions, short-term investments (including securities with daily put provisions) and federal funds sold. Cash flows are reported net for customer loan and deposit transactions, interest-bearing time deposits with other financial institutions and short-term borrowings with maturities of 90 days or less. Securities: Securities classified as held to maturity are carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities available for sale consist of those securities which might be sold prior to maturity due to changes in interest rates, prepayment risks, yield and availability of alternative investments, liquidity needs or other factors. Securities classified as available for sale are reported at fair value with unrealized holding gains or losses reported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried at cost. (Continued) F-35 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Premiums and discounts on securities are recognized in interest income using the interest method over the estimated life of the security. Gains and losses on the sale of securities available for sale are determined based upon amortized cost of the specific security sold. Securities are written down to fair value when a decline in fair value is not temporary. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) our ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. Loans and Leases: Loans and leases that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and an allowance for loan and lease losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when the loan or lease is impaired or payments are past due over 90 days. Payments received on such loans and leases are reported as principal reductions. In all cases, loans and leases are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans and leases is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans and leases are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Such loans are sold service released. 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 leases' 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. Transfer of Financial Assets: Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. (Continued) F-36 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Building and related components are depreciated using the straight-line method with useful lives ranging from 5 to 33 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. Long-term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. Foreclosed Assets: Assets acquired through or instead of foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed. Bank Owned Life Insurance: The Bank has purchased life insurance policies on certain key officers. Bank owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance. 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 123, Accounting for Stock-Based Compensation.
2004 2003 2002 ----------- ----------- ---------- Net income as reported $13,721,000 $10,016,000 $7,757,000 Deduct: Stock-based compensation expense determined under fair value based method 323,000 378,000 337,000 Pro forma net income 13,398,000 9,638,000 7,420,000 Basic earnings per share as reported $ 1.91 $ 1.65 $ 1.36 Pro forma basic earnings per share 1.87 1.59 1.30 Diluted earnings per share as reported $ 1.87 $ 1.61 $ 1.34 Pro forma diluted earnings per share 1.82 1.55 1.28
The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of grant date.
2004 2003 2002 ------ ------ ------- Risk-free interest rate 3.45% 3.25% 4.78% Expected option life 7 Years 7 Years 10 Years Expected stock price volatility 22% 22% 30% Dividend yield 1% 1% 0%
(Continued) F-37 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Financial Instruments and Loan Commitments: Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financials instruments are recorded when they are funded. Instruments, such as standby letters of credit that are considered financial guarantees in accordance with FASB Interpretation No. 45, are recorded at fair value. Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on- and off-balance sheet financial instruments does not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments. Earnings Per Share: Basic earnings per share is based on weighted average common shares outstanding during the period. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under stock options. Earnings per share are restated for all stock dividends, including the 5% stock dividend paid on May 3, 2004, February 3, 2003 and February 1, 2002. The fair value of shares issued in stock dividends is transferred from retained earnings to common stock. Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity. New Accounting Pronouncements: FAS 123, Revised, requires all public companies to record compensation cost for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This will apply to awards granted or modified after the first quarter or year beginning after June 15, 2005. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. Existing options that will vest after adoption date are expected to result in additional compensation expense of approximately $187,000 during the balance of 2005, and $36,000 in 2006 and $27,000 in 2007. There will be no significant effect on financial position as total equity will not change. SOP 03-3 requires that a valuation allowance for loans acquired in a transfer, including in a business combination, reflect only losses incurred after acquisition and should not be recorded at acquisition. It applies to any loan acquired in a transfer that showed evidence of credit quality deterioration since it was made. The effect of these new standards on the Corporation's financial position and results of operations is not expected to be material upon and after adoption. (Continued) F-38 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements. Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. Operating Segments: While management monitors the revenue streams of the various products and services offered, the identifiable segments are not material and operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of Mercantile's financial service operations are considered by management to be aggregated in one reportable operating segment. NOTE 2 - SECURITIES The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ----------- ---------- ---------- ----------- 2004 U.S. Government agency debt obligations $55,912,000 $241,000 $(128,000) $56,025,000 Mortgage-backed securities 37,711,000 255,000 (165,000) 37,801,000 ----------- -------- ---------- ----------- $93,623,000 $496,000 $(293,000) $93,826,000 =========== ======== ========== =========== 2003 U.S. Government agency debt obligations $34,014,000 $223,000 $(159,000) $34,078,000 Mortgage-backed securities 37,074,000 414,000 (145,000) 37,343,000 ----------- -------- ---------- ----------- $71,088,000 $637,000 $(304,000) $71,421,000 =========== ======== ========== ===========
(Continued) F-39 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 2 - SECURITIES (Continued) The carrying amount, unrecognized gains and losses, and fair value of securities held to maturity were as follows:
Gross Gross Carrying Unrecognized Unrecognized Fair Amount Gains Losses Value ----------- ------------ ------------ ----------- 2004 Municipal general obligation bonds $45,063,000 $2,066,000 $ (88,000) $47,041,000 Municipal revenue bonds 7,278,000 325,000 (23,000) 7,580,000 ----------- ---------- --------- ----------- $52,341,000 $2,391,000 $(111,000) $54,621,000 =========== ========== ========= =========== 2003 Municipal general obligation bonds $38,594,000 $1,829,000 $(122,000) $40,301,000 Municipal revenue bonds 6,518,000 303,000 (20,000) 6,801,000 ----------- ---------- --------- ----------- $45,112,000 $2,132,000 $(142,000) $47,102,000 =========== ========== ========= ===========
Securities with unrealized losses not recognized in income are as follows:
Less than 12 Months 12 Months or More Total ------------------------ ------------------------ ------------------------ Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss - ------------------------- ----------- ---------- ----------- ---------- ----------- ---------- 2004 U.S. Government agency debt obligations $ 1,976,000 $ (22,000) $ 3,893,000 $(106,000) $ 5,869,000 $(128,000) Mortgage-backed securities 5,666,000 (16,000) 10,532,000 (149,000) 16,198,000 (165,000) Municipal general obligation bonds 744,000 (8,000) 2,357,000 (80,000) 3,101,000 (88,000) Municipal revenue bonds 813,000 (9,000) 536,000 (14,000) 1,349,000 (23,000) ----------- ---------- ----------- ---------- ----------- ---------- $ 9,199,000 $ (55,000) $17,318,000 $(349,000) $26,517,000 $(404,000) =========== ========== =========== ========== =========== ========== 2003 U.S. Government agency debt obligations $ 5,827,000 $(159,000) $ 0 $ 0 $ 5,827,000 $(159,000) Mortgage-backed securities 12,975,000 (145,000) 0 0 12,975,000 (145,000) Municipal general obligation bonds 4,318,000 (118,000) 1,082,000 (4,000) 5,400,000 (122,000) Municipal revenue bonds 532,000 (20,000) 0 0 532,000 (20,000) ----------- ---------- ----------- ---------- ----------- ---------- $23,652,000 $(442,000) $ 1,082,000 $ (4,000) $24,734,000 $(446,000) =========== ========== =========== ========== =========== ==========
(Continued) F-40 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 2 - SECURITIES (Continued) We evaluate securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability we have to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer's financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer's financial condition. At December 31, 2004, $26.5 million in debt securities have unrealized losses with aggregate depreciation of 1.5% from the amortized cost basis. In analyzing an issuer's financial condition, we considered whether the securities were issued by the federal government or its agencies, whether downgrades by bond rating agencies had occurred, and industry analysts' reports. As we have the ability to hold debt securities until maturity, or for the foreseeable future if classified as available for sale, no declines are deemed to be other than temporary. The amortized cost and fair values of debt securities at year-end 2004, by contractual maturity, are shown below. The contractual maturity is utilized below for U.S. Government agency debt obligations and municipal bonds. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage backed securities, are shown separately. The maturities of securities and their weighted average yields at December 31, 2004 are shown in the following table. The yields for municipal securities are shown at their tax equivalent yield.
Held-to-Maturity Available-for-Sale ------------------------------------ ------------------------------------ Weighted Weighted Average Carrying Fair Average Amortized Fair Yield Amount Value Yield Cost Value -------- ----------- ----------- -------- ----------- ----------- Due in one year or less 6.89% $ 906,000 $ 924,000 NA $ 0 $ 0 Due from one to five years 6.88 4,947,000 5,289,000 NA 0 0 Due from five to ten years 6.79 9,771,000 10,460,000 5.04% 55,912,000 56,025,000 Due after ten years 6.67 36,717,000 37,948,000 NA 0 0 Mortgage-backed NA 0 0 4.75 37,711,000 37,801,000 ----------- ----------- ----------- ----------- 6.72% $52,341,000 $54,621,000 4.92% $93,623,000 $93,826,000 =========== =========== =========== ===========
During 2004, securities with an aggregate amortized cost basis of $1.7 million were sold, resulting in a gross realized gain of $78,000. During 2003, securities with an aggregate amortized cost basis of $15.7 million were sold, resulting in a gross realized gain of $324,000 and a gross realized loss of $3,000. During 2002, securities with a gross amortized cost basis of $13.7 million were sold, resulting in a gross realized gain of $270,000. At year-end 2004 and 2003, the amortized cost of securities issued by the state of Michigan and all its political subdivisions totaled $52.3 million and $45.1 million, with an estimated market value of $54.6 million and $47.1 million, respectively. Total securities of any one specific issuer, other than the U.S. Government and its agencies, did not exceed 10% of shareholders' equity. The carrying value of securities that are pledged to repurchase agreements and other deposits was $70.9 million and $61.4 million at December 31, 2004 and 2003, respectively. (Continued) F-41 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 3 - LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE LOSSES Year-end loans and leases are as follows:
December 31, 2004 December 31, 2003 Percent ---------------------- ---------------------- Increase/ Balance % Balance % (Decrease) -------------- ----- -------------- ----- ---------- Real Estate: Construction and land development $ 136,705,000 10.3% $ 117,649,000 11.4% 16.2% Secured by 1 - 4 family properties 122,635,000 9.3 92,339,000 8.9 32.8 Secured by multi- family properties 35,183,000 2.7 28,950,000 2.8 21.5 Secured by nonresidential properties 649,415,000 49.3 485,080,000 46.8 33.9 Commercial 365,615,000 27.8 304,800,000 29.4 20.0 Leases 2,573,000 0.2 2,309,000 0.2 11.4 Consumer 4,998,000 0.4 4,836,000 0.5 3.3 -------------- ----- -------------- ----- ---- $1,317,124,000 100.0% $1,035,963,000 100.0% 27.1% ============== ===== ============== ===== ====
Activity in the allowance for loan and lease losses is as follows:
2004 2003 2002 ----------- ----------- ----------- Beginning balance $14,379,000 $10,890,000 $ 8,494,000 Provision for loan and lease losses 4,674,000 3,800,000 3,002,000 Charge-offs (1,405,000) (596,000) (706,000) Recoveries 171,000 285,000 100,000 ----------- ----------- ----------- Ending balance $17,819,000 $14,379,000 $10,890,000 =========== =========== ===========
2004 2003 ---------- ---------- Impaired loans and leases were as follows: Year-end loans with no allocated allowance for loan and lease losses $ 0 $ 0 Year-end loans with allocated allowance for loan and lease losses 2,729,000 1,785,000 ---------- ---------- $2,729,000 $1,785,000 ========== ========== Amount of the allowance for loan and lease losses allocated $ 477,000 $ 321,000 Average of impaired loans during the year 2,845,000 581,000
The Bank recognized interest income of $21,000 on impaired loans during 2004 and $140,000 during 2003, all accounted for on a cash basis. The Bank did not recognize any interest income on impaired loans during 2002. Nonperforming loans includes both smaller balance homogenous loans that are collectively evaluated for impairment and individually classified impaired loans. (Continued) F-42 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 3 - LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE LOSSES (Continued) Nonperforming loans and leases were as follows: Loans and leases past due over 90 days still accruing interest $ 0 $1,552,000 Nonaccrual loans and leases 2,842,000 233,000 ---------- ---------- $2,842,000 $1,785,000 ========== ==========
Concentrations within the loan portfolio were as follows at year-end:
2004 2003 ----------------------------- ----------------------------- Percentage of Percentage of Balance Loan Portfolio Balance Loan Portfolio ------------ -------------- ------------ -------------- Commercial real estate loans to lessors of non-residential buildings $364,230,000 27.7% $259,690,000 25.1%
NOTE 4 - PREMISES AND EQUIPMENT, NET Year-end premises and equipment are as follows:
2004 2003 ----------- ----------- Land and improvements $ 6,482,000 $ 5,745,000 Buildings and leasehold improvements 16,547,000 8,183,000 Furniture and equipment 6,327,000 4,935,000 ----------- ----------- 29,356,000 18,863,000 Less: accumulated depreciation 4,784,000 3,558,000 ----------- ----------- $24,572,000 $15,305,000 =========== ===========
Depreciation expense in 2004, 2003 and 2002 totaled $1,248,000, $1,162,000 and $910,000, respectively. (Continued) F-43 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 5 - DEPOSITS Deposits at year-end are summarized as follows:
December 31, 2004 December 31, 2003 Percent ---------------------- -------------------- Increase/ Balance % Balance % (Decrease) -------------- ----- ------------ ----- ---------- Noninterest-bearing demand $ 101,742,000 8.8% $ 76,579,000 8.5% 32.9% Interest-bearing checking 37,649,000 3.2 34,241,000 3.8 10.0 Money market 10,528,000 0.9 8,290,000 0.9 27.0 Savings 129,374,000 11.2 101,710,000 11.3 27.2 Time, under $100,000 8,963,000 0.8 8,163,000 0.9 9.8 Time, $100,000 and over 99,760,000 8.6 82,288,000 9.1 21.2 -------------- ----- ------------ ----- ---- 388,016,000 33.5 311,271,000 34.5 24.7 Out-of-area time, under $100,000 90,829,000 7.8 98,079,000 10.9 (7.4) Out-of-area time, $100,000 and over 680,336,000 58.7 493,542,000 54.6 37.8 -------------- ----- ------------ ----- ---- 771,165,000 66.5 591,621,000 65.5 30.3 -------------- ----- ------------ ----- ---- $1,159,181,000 100.0% $902,892,000 100.0% 28.4% ============== ===== ============ ===== ====
Out-of-area certificates of deposit consist of certificates obtained from depositors outside of the primary market area. As of December 31, 2004, out-of-area certificates of deposit totaling $753.6 million were obtained through deposit brokers, with the remaining $17.6 million obtained directly from the depositors. The following table depicts the maturity distribution for time deposits at year-end.
2004 2003 ------------ ------------ In one year $609,055,000 $490,450,000 In two years 191,079,000 119,376,000 In three years 40,044,000 34,172,000 In four years 21,252,000 19,957,000 In five years 18,458,000 18,117,000 ------------ ------------ $879,888,000 $682,072,000 ============ ============
The following table depicts the maturity distribution for certificates of deposit with balances of $100,000 or more at year-end.
2004 2003 ------------ ------------ Up to three months $181,526,000 $123,040,000 Three months to six months 136,349,000 142,231,000 Six months to twelve months 229,645,000 146,488,000 Over twelve months 232,576,000 164,071,000 ------------ ------------ $780,096,000 $575,830,000 ============ ============
(Continued) F-44 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 6 - SHORT-TERM BORROWINGS Information relating to short-term borrowings, comprised entirely of securities sold under agreements to repurchase, at year-end is summarized below:
2004 2003 ----------- ----------- Outstanding balance at year-end $56,317,000 $49,545,000 Weighted average interest rate at year-end 1.90% 1.38% Average daily balance during the year 49,935,000 45,865,000 Weighted average interest rate during the year 1.57% 1.45% Maximum month end balance during the year 61,678,000 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 repurchase agreements are recorded as assets of the Bank and are primarily held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain large deposit customers as uninsured deposit equivalent investments. Repurchase agreements were secured by securities with a market value of $69.9 million and $60.4 million at year-end 2004 and 2003, respectively. NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows.
2004 2003 ------------ ----------- Maturities January 2005 through December 2006, fixed rates from 1.66% to 3.47%, averaging 2.51% 110,000,000 0 Maturities in May 2006, floating rates tied to Libor indices, averaging 2.32% 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 ------------ ----------- $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 the Bank, under a blanket lien arrangement. Our borrowing line of credit as of December 31, 2004 totaled $193.5 million. Maturities over the next five years are: 2005 $65,000,000 2006 55,000,000 2007 0 2008 0 2009 0
(Continued) F-45 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 8 - FEDERAL INCOME TAXES The consolidated provision for income taxes is as follows:
2004 2003 2002 ---------- ----------- ---------- Current $5,981,000 $ 5,153,000 $4,060,000 Deferred benefit (845,000) (1,253,000) (893,000) Effect of restating deferred tax asset @ 35% 0 (115,000) 0 ---------- ----------- ---------- Tax expense $5,136,000 $ 3,785,000 $3,167,000 ========== =========== ==========
Income tax expense was less than the amount computed by applying the statutory federal income tax rate to income before income taxes. The reasons for the difference are as follows:
2004 2003 2002 ---------- ---------- ---------- Statutory rates $6,600,000 $4,830,000 $3,714,000 Increase (decrease) from Tax-exempt interest (708,000) (606,000) (429,000) Life insurance (257,000) (273,000) (139,000) Effect of tax bracket surcharge 0 (100,000) 0 Rehabilitation tax credits (429,000) 0 0 Other (70,000) (66,000) 21,000 ---------- ---------- ---------- Tax expense $5,136,000 $3,785,000 $3,167,000 ========== ========== ==========
The net deferred tax asset recorded includes the following amounts of deferred tax assets and liabilities:
2004 2003 ---------- ---------- Deferred tax assets Allowance for loan and lease losses $6,237,000 $4,983,000 Deferred loan fees 401,000 360,000 Deferred compensation 563,000 390,000 Other 27,000 33,000 ---------- ---------- 7,228,000 5,766,000 Deferred tax liabilities Unrealized gain on securities available for sale 71,000 113,000 Depreciation 711,000 383,000 Other 407,000 118,000 ---------- ---------- 1,189,000 614,000 ---------- ---------- Net deferred tax asset $6,039,000 $5,152,000 ========== ==========
A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefits related to such assets will not be realized. Management has determined that no valuation allowance was required at year-end 2004 or 2003. (Continued) F-46 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 9 - STOCK OPTION PLANS Stock option plans are used to reward directors and employees and provide them with additional equity interest. Stock options granted to non-employee directors are at 125% of the market price on the date of grant, fully vest after five years and expire ten years from the date of grant. Stock options granted to employees are granted at the market price on the date of grant, generally fully vest after one year and expire ten years from the date of grant. At year-end 2004, there were 262,994 shares authorized for future option grants. Information about option grants follows. A summary of the activity in the plan is as follows.
2004 2003 2002 ------------------- ------------------- ------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price -------- -------- -------- -------- -------- -------- Outstanding at beginning of year 291,978 $14.98 285,466 $12.03 241,279 $10.61 Granted 42,050 40.16 39,761 32.13 47,106 19.39 Exercised (51,726) 10.14 (31,912) 9.43 (606) 9.51 Forfeited or expired (420) 30.81 (1,337) 28.78 (2,313) 14.41 -------- ------ -------- ------ -------- ------ Outstanding at end of year 281,882 $19.60 291,978 $14.98 285,466 $12.03 ======== ====== ======== ====== ======== ====== Options exercisable at year-end 219,354 $15.02 238,254 $11.84 229,731 $10.31 ======== ====== ======== ====== ======== ====== Fair value of options granted during year $ 10.86 $ 7.97 $ 9.50 ======== ======== ========
Options outstanding at year-end 2004 were as follows:
Outstanding Exercisable ------------------------------------- ------------------ Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Contractual Exercise Exercise Prices Number Life Price Number Price - -------- ------- ---------------- -------- ------- -------- $8.00 - $10.00 73,155 4.0 Years $ 8.92 73,155 $ 8.92 $10.01 - $12.00 43,009 4.1 Years 11.02 43,009 11.02 $14.01 - $16.00 33,550 6.8 Years 14.40 33,550 14.40 $18.01 - $20.00 44,952 7.6 Years 18.57 38,016 18.68 $22.01 - $24.00 6,612 7.8 Years 23.36 0 NA $30.01 - $32.00 32,254 8.8 Years 30.81 31,624 30.81 $38.01 - $40.00 41,850 9.7 Years 38.91 0 NA $46.01 - $48.00 6,500 9.8 Years 46.63 0 NA ------- --------- ------- Outstanding at year end 281,882 6.5 Years $19.60 219,354 $15.02 ======= ========= =======
(Continued) F-47 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 9 - STOCK OPTION PLANS (Continued) Options outstanding at year-end 2004, 2003 and 2002 were as follows:
2004 2003 2002 --------- --------- --------- Minimum exercise price $ 8.23 $ 8.23 $ 8.23 Maximum exercise price 46.63 38.52 23.36 Average remaining option term 6.5 Years 6.5 Years 6.8 Years
NOTE 10 - RELATED PARTIES Certain directors and executive officers of the Bank, including their immediate families and companies in which they are principal owners, were loan customers of the Bank. At year-end 2004 and 2003, the Bank had $14.2 million and $11.3 million in loan commitments to directors and executive officers, of which $10.2 million and $6.3 million were outstanding at year-end 2004 and 2003, respectively, as reflected in the following table.
2004 2003 ----------- ----------- Beginning balance $ 6,271,000 $ 2,951,000 New loans 5,209,000 4,914,000 Repayments (1,270,000) (1,594,000) ----------- ----------- Ending balance $10,210,000 $ 6,271,000 =========== ===========
Related party deposits and repurchase agreements totaled $15.5 million at year-end 2004 and $11.3 million at year-end 2003. NOTE 11 - COMMITMENTS AND OFF-BALANCE-SHEET RISK The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its 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 the 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. The 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. The 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. If required, estimated loss exposure resulting from these instruments is expensed and recorded as a liability. (Continued) F-48 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 11 - COMMITMENTS AND OFF-BALANCE-SHEET RISK (Continued) At year-end 2004 and 2003, the rates on existing off-balance sheet instruments were substantially equivalent to current market rates, considering the underlying credit standing of the counterparties. The Bank's maximum exposure to credit losses for loan commitments and standby letters of credit outstanding at year-end was as follows:
2004 2003 ------------ ------------ Commercial unused lines of credit $226,935,000 $176,943,000 Unused lines of credit secured by 1 - 4 family residential properties 24,988,000 19,020,000 Credit card unused lines of credit 8,307,000 8,990,000 Other consumer unused lines of credit 5,155,000 5,569,000 Commitments to make loans 55,440,000 73,570,000 Standby letters of credit 56,464,000 57,918,000 ------------ ------------ $377,289,000 $342,010,000 ============ ============
The following instruments are considered financial guarantees under FASB Interpretation 45. These instruments are carried at fair value.
2004 2003 ---------------------- ---------------------- Contract Carrying Contract Carrying Amount Value Amount Value ----------- -------- ----------- -------- Standby letters of credit $56,464,000 $226,000 $57,918,000 $296,000
The Bank was required to have $7.7 million and $4.5 million of cash on hand or on deposit with the Federal Reserve Bank of Chicago to meet regulatory reserve and clearing requirements at year-end 2004 and 2003. These balances do not earn interest. The Bank leases its downtown Grand Rapids facility under an operating lease agreement. Total rental expense for the lease for 2004, 2003 and 2002 was $180,000, $175,000 and $170,000, respectively. Future minimum rentals under this lease, which expires on August 31, 2007, as of year-end 2004 are as follows: 2005 $184,000 2006 184,000 2007 123,000 -------- $491,000 ========
NOTE 12 - BENEFIT PLANS Mercantile has a 401(k) benefit plan that covers substantially all of its employees. Mercantile's 2004, 2003 and 2002 matching 401(k) contribution charged to expense was $413,000, $327,000 and $239,000, respectively. The percent of Mercantile's matching contributions to the 401(k) is determined annually by the Board of Directors. The 401(k) benefit plan allows employee contributions up to 15% of their compensation, which are matched at 100% of the first 5% of the compensation contributed. Matching contributions are immediately vested. (Continued) F-49 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 12 - BENEFIT PLANS (Continued) Mercantile has a deferred compensation plan in which all persons serving on the Board of Directors may defer all or portions of annual retainer and meeting fees, with distributions to be paid only upon termination of service as a director. The deferred amounts are categorized on Mercantile's financial statements as other borrowed money. The deferred balances are paid interest at a rate equal to the prime rate, adjusted at the beginning of each calendar quarter. Interest expense for the plan during 2004, 2003 and 2002 was $21,000, $15,000 and $11,000, respectively. Mercantile has a non-qualified deferred compensation program in which selected officers may defer all or portions of salary and bonus payments. The deferred amounts are categorized on Mercantile's financial statements as other borrowed money. The deferred balances are paid interest at a rate equal to the prime rate, adjusted at the beginning of each calendar quarter. Interest expense for the plan during 2004, 2003 and 2002 was $38,000, $22,000 and $10,000, respectively. The Mercantile Bank Corporation Employee Stock Purchase Plan of 2002 ("Stock Purchase Plan") is a non-compensatory plan intended to encourage full- and part-time employees of Mercantile and its subsidiaries to promote the best interests of Mercantile and to align employees' interests with the interests' of Mercantile's shareholders by permitting employees to purchase shares of Mercantile common stock through regular payroll deductions. Shares are purchased on the last business day of each calendar quarter at a price equal to the average, rounded to the nearest whole cent, of the highest and lowest sales prices of Mercantile's common stock reported on The Nasdaq Stock Market. Originally, 25,000 shares of common stock may be issued under the Stock Purchase Plan; however, the number of shares has been and may continue to be adjusted in the future to reflect stock dividends and other changes in Mercantile's capitalization. The numbers of shares issued under the Stock Purchase Plan totaled 2,167 and 1,974 in 2004 and 2003, respectively. As of December 31, 2004, there were 23,421 shares available under the Stock Purchase Plan. NOTE 13 - FAIR VALUES OF FINANCIAL INSTRUMENTS Carrying amount and estimated fair values of financial instruments were as follows at year-end.
2004 2003 ------------------------------- ------------------------------- Carrying Fair Carrying Fair Values Values Values Values -------------- -------------- -------------- -------------- Financial assets Cash and cash equivalents $ 20,811,000 $ 20,811,000 $ 16,564,000 $ 16,564,000 Securities available for sale 93,826,000 93,826,000 71,421,000 71,421,000 Securities held to maturity 52,341,000 54,621,000 45,112,000 47,102,000 Federal Home Loan Bank stock 6,798,000 6,798,000 4,977,000 4,977,000 Loans, net 1,299,305,000 1,316,831,000 1,021,584,000 1,038,404,000 Bank owned life insurance policies 23,750,000 23,750,000 16,441,000 16,441,000 Accrued interest receivable 5,644,000 5,644,000 4,098,000 4,098,000 Financial liabilities Deposits 1,159,181,000 1,155,016,000 902,892,000 903,278,000 Securities sold under agreements to repurchase 56,317,000 56,317,000 49,545,000 49,545,000 Federal Home Loan Bank advances 120,000,000 119,936,000 90,000,000 90,305,000 Accrued interest payable 6,297,000 6,297,000 4,799,000 4,799,000 Subordinated debentures 32,990,000 32,990,000 16,495,000 23,088,000
(Continued) F-50 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 13 - FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued) Carrying amount is the estimated fair value for cash and cash equivalents, Federal Home Loan Bank stock, accrued interest receivable and payable, bank owned life insurance policies, demand deposits, securities sold under agreements to repurchase, and variable rate loans or deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair value of subordinated debentures and Federal Home Loan Bank advances is based on current rates for similar financing. Fair value of off balance sheet items is estimated to be nominal. NOTE 14 - EARNINGS PER SHARE The factors used in the earnings per share computation follow.
2004 2003 2002 ----------- ----------- ---------- Basic Net income $13,721,000 $10,016,000 $7,757,000 =========== =========== ========== Weighted average common shares outstanding 7,174,320 6,070,648 5,675,988 ----------- ----------- ---------- Basic earnings per common share $ 1.91 $ 1.65 $ 1.37 =========== =========== ========== Diluted Net income $13,721,000 $10,016,000 $7,757,000 =========== =========== ========== Weighted average common shares outstanding for basic earnings per common share 7,174,320 6,070,648 5,675,988 Add: Dilutive effects of assumed exercises of stock options 179,693 145,010 102,501 ----------- ----------- ---------- Average shares and dilutive potential common shares 7,354,013 6,215,658 5,778,489 =========== =========== ========== Diluted earnings per common share $ 1.87 $ 1.61 $ 1.34 =========== =========== ==========
Stock options for 48,350, 37,730 and 44,878 shares of common stock were not considered in computing diluted earnings per common share for 2004, 2003 and 2002, respectively, because they were antidilutive. (Continued) F-51 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 15 - SUBORDINATED DEBENTURES Mercantile Trust, a business trust formed by the company, was incorporated in 2004 for the purpose of issuing Series A and Series B Preferred Securities. On September 16, 2004, Mercantile Trust sold the Series A Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series A Common Securities to Mercantile. The proceeds of the Series A Preferred Securities and the Series A Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series A Floating Rate Notes that were issued by Mercantile on September 16, 2004. Mercantile used the proceeds of the Series A Floating Rate Notes to finance the redemption on September 17, 2004 of the $16.0 million of 9.60% Cumulative Preferred Securities issued in 1999 by MBWM Capital Trust I. On December 10, 2004, Mercantile Trust sold the Series B Preferred Securities in a private sale for $16.0 million, and also sold $495,000 of Series B Common Securities to Mercantile. The proceeds of the Series B Preferred Securities and the Series B Common Securities were used by Mercantile Trust to purchase $16,495,000 of Series B Floating Rate Notes that were issued by Mercantile on December 10, 2004. Substantially all of the net proceeds of the Series B Floating Rate Notes were contributed to our bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. The only significant assets of Mercantile Trust are the Series A and Series B Floating Rate Notes, and the only significant liabilities of Mercantile Trust are the Series A and Series B Preferred Securities. The Series A and Series B Floating Rate Notes are categorized on the company's consolidated balance sheet as subordinated debentures and the interest expense is recorded on the company's consolidated statement of income under interest expense on long-term borrowings. NOTE 16 - SALE OF COMMON STOCK During 2003, Mercantile sold in aggregate approximately 1.4 million shares of common stock, raising $43.0 million net of issuance costs. Substantially all of the net proceeds were contributed to the Bank as capital to provide support for asset growth, fund investments in loans and securities and for general corporate purposes. NOTE 17 - REGULATORY MATTERS Mercantile and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. 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 an institution is adequately capitalized, regulatory approval is required to accept brokered deposits. If an institution is undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required. At year-end 2004 and 2003, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that we believe has changed the Bank's category. (Continued) F-52 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 17 - REGULATORY MATTERS (Continued) At year end, actual capital levels (in thousands) and minimum required levels for Mercantile and the Bank were:
Minimum Required to be Well Minimum Required Capitalized Under for Capital Prompt Corrective Actual Adequacy Purposes Action Regulations ---------------- ----------------- ------------------ Amount Ratio Amount Ratio Amount Ratio -------- ----- -------- ----- -------- ----- 2004 Total capital (to risk weighted assets) Consolidated $191,304 13.0% $117,426 8.0% $146,782 10.0% Bank 188,075 12.8 117,288 8.0 146,610 10.0 Tier 1 capital (to risk weighted assets) Consolidated 173,485 11.8 58,713 4.0 88,070 6.0 Bank 170,256 11.6 58,644 4.0 87,966 6.0 Tier 1 capital (to average assets) Consolidated 173,485 11.5 60,182 4.0 75,227 5.0 Bank 170,256 11.3 60,088 4.0 75,110 5.0 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
Federal and state banking laws and regulations place certain restrictions on the amount of dividends the Bank can transfer to Mercantile and on the capital levels that must be maintained. At year-end 2004, under the most restrictive of these regulations (to remain well capitalized), the Bank could distribute approximately $38.3 million to Mercantile as dividends without prior regulatory approval. The capital levels as of year-end 2004 include $32.0 million trust preferred securities issued by Mercantile Trust in September 2004 and December 2004 subject to certain limitations. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in Tier 1 capital of Mercantile to 25% of total Tier 1 capital. At year-end 2004, all $32.0 million of the trust preferred securities were included as Tier 1 capital of Mercantile. (Continued) F-53 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 17 - REGULATORY MATTERS (Continued) The capital levels as of year-end 2003 include $16.0 million trust preferred securities issued by MBWM Capital Trust I in September 1999 subject to certain limitations. Federal Reserve guidelines limit the amount of trust preferred securities which can be included in Tier 1 capital of Mercantile to 25% of total Tier 1 capital. At year-end 2003, all $16.0 million of the trust preferred securities were included as Tier 1 capital of Mercantile. NOTE 18 - OTHER COMPREHENSIVE INCOME/(LOSS) Other comprehensive income/(loss) components and related taxes were as follows.
2004 2003 2002 --------- ----------- ---------- Unrealized holding gains and losses on available-for-sale securities $(208,000) $(1,586,000) $1,249,000 Reclassification adjustments for gains and losses later recognized in income (78,000) (321,000) (270,000) --------- ----------- ---------- Net unrealized gains and losses (130,000) (1,265,000) 979,000 Tax effect of unrealized holding gains and losses on available-for-sale securities 70,000 539,000 (425,000) Tax effect of reclassification adjustments for gains and losses later recognized in income (28,000) (108,000) 92,000 --------- ----------- ---------- Other comprehensive income/(loss) $ (88,000) $ (834,000) $ 646,000 ========= =========== ==========
NOTE 19 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Earnings per Share Interest Net Interest Net --------------------- Income Income Income Basic Fully Diluted ----------- ------------ ---------- ----- ------------- 2004 First quarter $15,354,000 $ 9,489,000 $2,973,000 $0.42 $0.41 Second quarter 16,130,000 10,000,000 3,146,000 0.44 0.43 Third quarter 17,819,000 10,856,000 3,114,000 0.43 0.42 Fourth quarter 19,719,000 12,082,000 4,488,000 0.62 0.61 2003 First quarter $12,675,000 $ 6,794,000 $2,233,000 $0.39 $0.38 Second quarter 13,433,000 7,511,000 2,540,000 0.45 0.44 Third quarter 13,854,000 8,057,000 2,228,000 0.38 0.37 Fourth quarter 14,696,000 8,949,000 3,015,000 0.43 0.42 2002 First quarter $11,040,000 $ 5,034,000 $1,604,000 $0.28 $0.29 Second quarter 11,639,000 5,735,000 1,716,000 0.30 0.29 Third quarter 12,318,000 6,282,000 2,156,000 0.38 0.37 Fourth quarter 12,635,000 6,603,000 2,281,000 0.40 0.39
(Continued) F-54 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 20 - MERCANTILE BANK CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL STATEMENTS Following are condensed parent company only financial statements. CONDENSED BALANCE SHEETS
2004 2003 ------------ ------------ ASSETS Cash and cash equivalents $ 1,644,000 $ 1,408,000 Investment in bank subsidiary 170,389,000 142,791,000 Other assets 2,792,000 2,855,000 ------------ ------------ Total assets $174,825,000 $147,054,000 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities $ 218,000 $ 358,000 Subordinated debentures 32,990,000 16,495,000 Shareholders' equity 141,617,000 130,201,000 ------------ ------------ Total liabilities and shareholders' equity $174,825,000 $147,054,000 ============ ============
CONDENSED STATEMENTS OF INCOME
2004 2003 2002 ----------- ----------- ---------- Income Dividends from subsidiaries $ 4,032,000 $ 3,455,000 $1,583,000 Other 25,000 14,000 18,000 ----------- ----------- ---------- Total income 4,057,000 3,469,000 1,601,000 Expenses Interest expense 1,402,000 1,617,000 1,617,000 Other operating expenses 1,666,000 611,000 512,000 ----------- ----------- ---------- Total expenses 3,068,000 2,228,000 2,129,000 ----------- ----------- ---------- INCOME (LOSS) BEFORE INCOME TAX AND EQUITY IN UNDISTRIBUTED NET INCOME (LOSS) OF SUBSIDIARIES 989,000 1,241,000 (528,000) Federal income tax expense (benefit) (1,051,000) (724,000) (702,000) Equity in undistributed net income of subsidiary 11,681,000 8,051,000 7,583,000 ----------- ----------- ---------- NET INCOME $13,721,000 $10,016,000 $7,757,000 =========== =========== ==========
(Continued) F-55 MERCANTILE BANK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 and 2003 NOTE 20 - MERCANTILE BANK CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL STATEMENTS (Continued) CONDENSED STATEMENT OF CASH FLOWS
2004 2003 2002 ------------ ------------ ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 13,721,000 $ 10,016,000 $ 7,757,000 Adjustments to reconcile net income to net cash from operating activities Equity in undistributed income of subsidiary (11,681,000) (8,051,000) (7,583,000) Change in other assets 553,000 95,000 17,000 Change in other liabilities (140,000) (82,000) 60,000 ------------ ------------ ----------- Net cash from operating activities 2,453,000 1,978,000 251,000 CASH FLOWS FROM INVESTING ACTIVITIES Net capital investment into subsidiaries (16,495,000) (42,600,000) 0 ------------ ------------ ----------- Net cash from investing activities (16,495,000) (42,600,000) 0 CASH FLOWS FROM FINANCING ACTIVITIES Net proceeds from sale of common stock 0 42,818,000 (37,000) Proceeds from the issuance of subordinated debentures 32,990,000 0 0 Pay-off of subordinated debentures (16,495,000) 0 0 Stock option exercises, net 137,000 36,000 6,000 Employee stock purchase plan 79,000 57,000 0 Dividend reinvestment plan 123,000 119,000 0 Cash dividends (2,552,000) (1,845,000) 0 Fraction shares paid (4,000) 0 (1,000) ------------ ------------ ----------- Net cash from financing activities 14,278,000 41,185,000 (32,000) ------------ ------------ ----------- Net change in cash and cash equivalents 236,000 563,000 219,000 Cash and cash equivalents at beginning of period 1,408,000 845,000 626,000 ------------ ------------ ----------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,644,000 $ 1,408,000 $ 845,000 ============ ============ ===========
F-56 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 February 24, 2005. MERCANTILE BANK CORPORATION /s/ Gerald R. Johnson, Jr. ------------------------------------------------- Gerald R. Johnson, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on February 24, 2005. /s/ Betty S. Burton /s/ Susan K. Jones - ------------------------------------- ---------------------------------------- Betty S. Burton, Director Susan K. Jones, Director /s/ David M. Cassard /s/ Lawrence W. Larsen - ------------------------------------- ---------------------------------------- David M. Cassard, Director Lawrence W. Larsen, Director /s/ Edward J. Clark /s/ Calvin D. Murdock - ------------------------------------- ---------------------------------------- Edward J. Clark, Director Calvin D. Murdock, Director /s/ Peter A. Cordes /s/ Michael H. Price - ------------------------------------- ---------------------------------------- Peter A. Cordes, Director Michael H. Price, Director, President and Chief Operating Officer /s/ C. John Gill /s/ Merle J. Prins - ------------------------------------- ---------------------------------------- C. John Gill, Director Merle J. Prins, Director /s/ Doyle A. Hayes /s/ Dale J. Visser - ------------------------------------- ---------------------------------------- Doyle A. Hayes, Director Dale J. Visser, Director /s/ David M. Hecht /s/ Donald Williams, Sr. - ------------------------------------- ---------------------------------------- David M. Hecht, Director Donald Williams, Sr., Director /s/ Gerald R. Johnson, Jr. /s/ Charles E. Christmas - ------------------------------------- ---------------------------------------- Gerald R. Johnson, Jr., Chairman of Charles E. Christmas, Senior Vice the Board and Chief Executive President, Chief Financial Officer Officer (principal executive and Treasurer (principal financial officer) and accounting officer) EXHIBIT INDEX
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 3.1 Our Articles of Incorporation are incorporated by reference to exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2004 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 10.1 Our 1997 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 * 10.2 Our 2000 Employee Stock Option Plan is incorporated by reference to exhibit 10.14 of our Form 10-K for the year ended December 31, 2000 * 10.3 Our 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 10-Q for the quarter ended September 30, 2004 * 10.4 Form of Stock Option Agreement for options under the 2004 Employee Stock Option Plan is incorporated by reference to exhibit 10.2 of our Form 10-Q for the quarter ended September 30, 2004 * 10.5 Our Independent Director Stock Option Plan is incorporated by reference to exhibit 10.26 of our Form 10-K for the year ended December 31, 2002 * 10.6 Form of Stock Option Agreement for options under the Independent Director Stock Option Plan is incorporated by reference to exhibit 10.1 of our Form 8-K dated October 21, 2004 * 10.7 Nonlender Bonus Plan is incorporated by reference to exhibit 10.3 of our Form 10-Q for the quarter ended September 30, 2004 * 10.8 Mercantile Bank of West Michigan Deferred Compensation Plan for Members of the Board of Directors (1999) is incorporated by reference to Exhibit 10.6 of the Registration Statement of the company and our trust on Form SB-2 (Commission File Nos. 333-84313 and 333-84313-01) that became effective on September 13, 1999 * 10.9 Lease Agreement between our bank and Division Avenue Partners, L.L.C. dated August 16, 1997, is incorporated by reference to exhibit 10.2 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective October 23, 1997 10.10 Agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.3 of our Registration Statement on Form SB-2 (Commission File No. 333-33081) that became effective on October 23, 1997 10.11 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated May 12, 2000 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.15 of our Form 10-K for the year ended December 31, 2000
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 10.12 Extension Agreement of Data Processing Contract between Fiserv Solutions, Inc. and our bank dated November 22, 2002 extending the agreement between Fiserv Solutions, Inc. and our bank dated September 10, 1997, is incorporated by reference to exhibit 10.5 of our Form 10-K for the year ended December 31, 2002 10.13 Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2001 * 10.14 Amended and Restated Employment Agreement dated as of October 18, 2001, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2001 * 10.15 Employment Agreement dated as of October 18, 2001, among the company, our bank and Robert B. Kaminski, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * 10.16 Employment Agreement dated as of October 18, 2001, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2001 * 10.17 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Gerald R. Johnson, Jr., is incorporated by reference to exhibit 10.21 of our Form 10-K for the year ended December 31, 2002 * 10.18 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Michael H. Price, is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2002 * 10.19 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Robert B. Kaminski, is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2002 * 10.20 Amendment to Employment Agreement dated as of October 17, 2002, among the company, our bank and Charles E. Christmas, is incorporated by reference to exhibit 10.24 of our Form 10-K for the year ended December 31, 2002 * 10.21 Amendment to Employment Agreement dated as of October 28, 2004, among the company, our bank and Robert B. Kaminski * 10.22 Agreement between our bank and Visser Brothers Construction Inc. dated May 8, 2002, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum, is incorporated by reference to exhibit 10.25 of our Form 10-K for the year ended December 31, 2002 10.23 Agreement between our real estate company and Visser Brothers, Inc. dated November 20, 2003, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum is incorporated by reference to exhibit 10.22 of our Form 10-K for the year ended December 31, 2003 10.24 Agreement between our bank and Rockford Construction Company, Inc., dated December 3, 2003, on Standard Form of Agreement Between Owner and Contractor where the basis of payment is a stipulated sum is incorporated by reference to exhibit 10.23 of our Form 10-K for the year ended December 31, 2003
EXHIBIT NO. EXHIBIT DESCRIPTION - ----------- ------------------- 10.25 Junior Subordinated Indenture between us and Wilmington Trust Company dated September 16, 2004 providing for the issuance of the Series A and Series B Floating Rate Junior Subordinated Notes due 2034 is incorporated by reference to exhibit 10.1 of our Form 8-K dated December 15, 2004 10.26 Amended and Restated Trust Agreement dated September 16, 2004 for Mercantile Bank Capital Trust I is incorporated by reference to exhibit 10.2 of our Form 8-K dated December 15, 2004 10.27 Placement Agreement between us, Mercantile Bank Capital Trust I, and SunTrust Capital Markets, Inc. dated September 16, 2004 is incorporated by reference to exhibit 10.3 of our Form 8-K dated December 15, 2004 10.28 Guarantee Agreement dated September 16, 2004 between Mercantile as Guarantor and Wilmington Trust Company as Guarantee Trustee is incorporated by reference to exhibit 10.4 of our Form 8-K dated December 15, 2004 21 Subsidiaries of the company 23 Consent of Independent Registered Public Accounting Firm 31 Rule 13a-14(a) Certifications 32.1 Section 1350 Chief Executive Officer Certification 32.2 Section 1350 Chief Financial Officer Certification
* - Management contract or compensatory plan EX-10.21 2 k92009exv10w21.txt AMENDMENT TO EMPLOYMENT AGREEMENT DATED AS OF OCTOBER 28, 2004 EXHIBIT 10.21 October 28, 2004 Mercantile Bank Corporation Mercantile Bank of West Michigan 5650 Byron Center Avenue SW Wyoming, Michigan 49509 Re: Second Amendment to Employment Agreement dated October 18, 2001 Ladies and Gentlemen: This letter confirms our agreement reached today regarding the Employment Agreement dated as of October 18, 2001, by and among you and me, as amended by the letter agreement dated October 17, 2002 (as amended, the "Employment Agreement"). We have agreed that all references in the Employment Agreement to my titles as Senior Vice President and Secretary of Mercantile Bank Corporation or as Senior Vice President, Chief Operating Officer and Chief Loan Review Officer of Mercantile Bank of West Michigan, are amended respectively to refer to Executive Vice President and Secretary of Mercantile Bank Corporation and Executive Vice President and Chief Operating Officer of Mercantile Bank of West Michigan, to take into account the promotion I previously received that changed my Vice President title from Senior Vice President to Executive Vice President, and to omit the Chief Loan Review Officer title from the Employment Agreement. Except as specifically amended by this letter, all of the terms of the Employment Agreement remain in full force and effect. This letter may be executed in counterparts, and is governed by Michigan law. /s/ Robert B. Kaminski ---------------------------------------- Robert B. Kaminski MERCANTILE BANK CORPORATION By: /s/ Gerald R. Johnson, Jr. ---------------------------------------- Its: Chairman & Chief Executive Officer MERCANTILE BANK OF WEST MICHIGAN By: /s/ Gerald R. Johnson, Jr. ---------------------------------------- Its: Chairman EX-21 3 k92009exv21.txt SUBSIDIARIES OF THE COMPANY EXHIBIT 21 SUBSIDIARIES OF MERCANTILE BANK CORPORATION Mercantile Bank of West Michigan, a Michigan banking corporation Wholly-owned bank subsidiary of Mercantile Bank Corporation Mercantile Bank Capital Trust I A Delaware business trust subsidiary of Mercantile Bank Corporation Mercantile Bank Mortgage Company, LLC, a Michigan limited liability company 99% owned by Mercantile Bank of West Michigan and 1% owned by Mercantile Insurance Center, Inc. Mercantile BIDCO, Inc, a Michigan Business and Industrial Development Company Wholly-owned subsidiary of Mercantile Bank of West Michigan Mercantile Insurance Center, Inc, a Michigan business corporation Wholly-owned subsidiary of Mercantile Bank of West Michigan Mercantile Bank Real Estate Co., LLC, a Michigan limited liability company 99% owned by Mercantile Bank of West Michigan and 1% owned by Mercantile Insurance Center, Inc. All of the subsidiaries named above with the exception of Mercantile Bank Capital Trust I were organized under the laws of the State of Michigan. Mercantile Bank Capital Trust I was organized under the laws of the State of Delaware. EX-23 4 k92009exv23.txt CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM EXHIBIT 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statements of Mercantile Bank Corporation on Form S-8 (Registration Nos. 333-52620, 333-91434, 333-99853 and 333-103242) and Form S-3 (Registration Nos. 333-59154, 333-103376, 333- 108929, and 333-107814) of our reports dated February 24, 2005 with respect to the 2004 consolidated financial statements of Mercantile Bank Corporation, and management's assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, which reports are included in the 2004 Annual Report on Form 10-K of Mercantile Bank Corporation for the year ended December 31, 2004. /s/ Crow Chizek and Company LLC Crowe Chizek and Company LLC Grand Rapids, Michigan March 10, 2005 EX-31 5 k92009exv31.txt RULE 13A-14(A) CERTIFICATIONS EXHIBIT 31 RULE 13A-14(A) CERTIFICATIONS I, GERALD R. JOHNSON, JR., CHAIRMAN AND CHIEF EXECUTIVE OFFICER OF MERCANTILE BANK CORPORATION, CERTIFY THAT: 1. I have reviewed this report on Form 10-K of Mercantile Bank Corporation (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Aect Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 24, 2005 /s/ Gerald R. Johnson, Jr. ---------------------------------------- Gerald R. Johnson, Jr. Chairman and Chief Executive Officer I, CHARLES E. CHRISTMAS, SENIOR VICE PRESIDENT, CHIEF FINANCIAL OFFICER AND TREASURER OF MERCANTILE BANK CORPORATION, CERTIFY THAT: 1. I have reviewed this report on Form 10-K of Mercantile Bank Corporation (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 24, 2005 /s/ Charles E. Christmas ---------------------------------------- Charles E. Christmas. Senior Vice President, Chief Financial Officer and Treasurer EX-32.1 6 k92009exv32w1.txt SECTION 1350 CHIEF EXECUTIVE OFFICER CERTIFICATION EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 This certification is provided pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, and accompanies the annual report on Form 10-K for the year ended December 31, 2004 (the "Form 10-K") of Mercantile Bank Corporation (the "Issuer"). I, Gerald R. Johnson, Jr., Chairman and Chief Executive Officer of the Issuer, certify that: (i) the Form 10-K fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)); and (ii) the information contained in the Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Issuer. Dated: February 24, 2005 /s/ Gerald R. Johnson, Jr. ---------------------------------------- Gerald R. Johnson, Jr. Chairman and Chief Executive Officer EX-32.2 7 k92009exv32w2.txt SECTION 1350 CHIEF FINANCIAL OFFICER CERTIFICATION EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 This certification is provided pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, and accompanies the annual report on Form 10-K for the year ended December 31, 2004 (the "Form 10-K") of Mercantile Bank Corporation (the "Issuer"). I, Charles E. Christmas, Senior Vice President, Chief Financial Officer and Treasurer of the Issuer, certify that: (i) the Form 10-K fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)); and (ii) the information contained in the Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Issuer. Dated: February 24, 2005 /s/ Charles E. Christmas ---------------------------------------- Charles E. Christmas Senior Vice President, Chief Financial Officer and Treasurer -----END PRIVACY-ENHANCED MESSAGE-----