EX-13 3 dex13.txt ANNUAL REPORT TO SHAREHOLDERS Exhibit 13.1 Financial Information 27 Selected Consolidated Financial Data 28 Quarterly Financial Data 29 Management's Discussion and Analysis 30 Report of Independent Auditors 44 Consolidated Financial Statements 45 Notes to Consolidated Financial Statements 50 Shareholder Information 64 28 Macatawa Bank Corporation Selected Consolidated Financial Data The following selected consolidated financial and other data are derived from the Company's Financial Statements and should be read with the Consolidated Financial Statements and Notes thereto, and Management's Discussion and Analysis of Financial Condition and Results of Operations. The Consolidated Balance Sheets as of December 31, 2002 and 2001, and the Consolidated Statements of Income for the years ended December 31, 2002, 2001, and 2000, are included elsewhere in this Annual Report.
At or For the Year Ended December 31 (Dollars in thousands, except share and per share data) 2002 2001 2000 1999 1998 ------------------------------------------------------- ---------- ---------- ---------- ---------- ---------- Financial Condition Total assets $1,176,583 $ 670,203 $ 499,813 $ 344,921 $ 189,229 Securities 90,170 64,316 48,669 28,281 27,007 Loans 961,038 545,693 410,676 285,374 137,882 Deposits 920,873 526,192 398,617 279,390 166,989 Shareholders' equity 113,974 66,502 38,128 34,526 19,611 Share Information Basic earnings/(loss) per common share $ 1.29 $ 1.08 $ .87 $ .21 $ (1.13) Diluted earnings/(loss) per common share 1.27 1.07 .87 .21 (1.13) Book value per common share 14.44 12.03 9.91 8.98 7.52 Weighted average dilutive shares outstanding 7,465,260 4,795,992 3,859,493 3,345,290 2,187,305 Shares outstanding at end of period 7,891,502 5,519,489 3,844,661 3,843,881 2,644,303 Operations Interest income $ 57,252 $ 42,685 $ 34,338 $ 20,000 $ 6,804 Interest expense 22,902 20,927 17,739 9,428 3,190 Net interest income 34,350 21,758 16,599 10,572 3,614 Provision for loan losses 3,321 2,285 1,931 1,967 2,023 Net interest income after provision for loan losses 31,029 19,473 14,668 8,605 1,591 Total noninterest income 7,323 3,683 2,052 1,528 683 Total noninterest expense 24,187 15,543 12,672 9,440 4,763 Income/(loss) before tax 14,165 7,613 4,048 693 (2,489) Federal income tax 4,652 2,497 699 -- -- Net income/(loss) $ 9,513 $ 5,116 $ 3,349 $ 693 $ (2,489) Performance Ratios Return on average equity 9.46% 9.58% 9.31% 2.72% (15.15)% Return on average assets 0.95% 0.88% 0.80% 0.26% (2.70)% Yield on average interest-earning assets 6.16% 7.82% 8.85% 8.27% 7.93% Cost on average interest-bearing liabilities 2.82% 4.39% 5.20% 4.51% 4.77% Average net interest spread 3.34% 3.43% 3.65% 3.76% 3.16% Average net interest margin 3.69% 3.98% 4.18% 4.37% 4.21% Efficiency ratio 58.04% 61.09% 67.95% 78.02% 110.84% Capital Ratios Equity to assets 9.69% 9.92% 7.63% 10.01% 10.36% Total risk-based capital ratio 9.89% 12.85% 10.36% 14.16% 12.40% Credit Quality Ratios Allowance for loan losses to total loans 1.40% 1.41% 1.43% 1.40% 1.47% Nonperforming assets to total assets 0.28% 0.36% 0.04% 0.03% 0.00% Net charge-offs to average loans 0.12% 0.09% 0.02% 0.00% 0.00%
2002 Annual Report 29 Quarterly Financial Data (Unaudited) A summary of selected quarterly results of operations for the years ended December 31, 2002 follows:
Three Months Ended (Dollars in thousands, except share and per share data) March 31 June 30 September 30 December 31 ------------------------------------------------------- -------- ------- ------------ ----------- 2002 Interest income $10,522 $15,000 $15,810 $15,918 Net interest income 6,157 8,814 9,474 9,902 Provision for loan losses 705 921 705 990 Income before tax 2,244 3,495 4,080 4,346 Net income 1,514 2,350 2,735 2,915 Net income per share Basic .28 .29 .34 .37 Diluted .27 .29 .34 .36 2001 Interest income $10,280 $10,639 $11,108 $10,658 Net interest income 4,831 5,195 5,675 6,057 Provision for loan losses 522 502 565 696 Income before tax 1,637 1,784 2,003 2,189 Net income 1,091 1,202 1,351 1,471 Net income per share Basic .29 .29 .25 .27 Diluted .28 .29 .24 .26
30 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion and analysis of financial condition and results of operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in such forward-looking statements. The following section presents additional information to assess the financial condition and results of operations of the Company. This section should be read in conjunction with the consolidated financial statements and the supplemental financial data contained elsewhere in this Annual Report. Overview Macatawa Bank Corporation is a Michigan corporation and is the bank holding company for two wholly owned banking subsidiaries, Macatawa Bank and Grand Bank, as well as Macatawa Bank Brokerage Services. Effective January 9, 2002, Macatawa Bank Corporation elected to become a financial holding company pursuant to Title 1 of the Gramm-Leach-Bliley Act. Macatawa Bank commenced operations on November 25, 1997. Grand Bank was formed in 1987 and operated from a single location in Grand Rapids, Michigan. Grand Bank became a wholly owned subsidiary effective April 1, 2002 upon the completion of the acquisition of Grand Bank Financial Corporation (GBFC), and its results are included in the consolidated statements of income since this effective date. Both Macatawa Bank and Grand Bank are Michigan chartered banks with depository accounts insured by the Federal Deposit Insurance Corporation. The banks operate seventeen branch offices and three lending and operational service facilities, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan. Macatawa Bank Brokerage Services was formed in October 2001 and gained approval in June 2002 from the NASD to commence operations as a broker/dealer. Macatawa Bank Brokerage Services provides various brokerage services including discount brokerage, personal financial planning and consultation regarding mutual funds. Macatawa Bank Mortgage Company and Grand Bank Mortgage Company, subsidiaries of Macatawa Bank and Grand Bank, respectively, originate and sell residential mortgage loans into the secondary market on a servicing released basis. To achieve further synergies from the Grand Bank acquisition, we merged Grand Bank into Macatawa Bank effective January 1, 2003 with the combined bank named Macatawa Bank. This is expected to create more operational efficiencies and simplify service to customers. While maintaining asset quality and improving profitability, we have experienced rapid and substantial growth since opening Macatawa Bank in November 1997. We first became profitable in 1999 with net income for that year of $693 thousand. Net income for 2000 was $3.3 million, for 2001 was $5.1 million, and for 2002 was $9.5 million. Since our inception in 1997 we have raised approximately $60.6 million in capital through private and public common stock offerings to facilitate our growth and progress over these years. In conjunction with the acquisition of GBFC we issued 2,472,000 shares of stock in exchange for all of the outstanding stock of GBFC. The West Michigan markets within which we operate are growing markets. Because of their growth and our ability to provide highly personalized service, these markets have provided significant expansion opportunities for us. In addition, acquisitions of banks within our markets by large banking institutions headquartered outside of West Michigan have provided us additional opportunity to gain market share. Grand Rapids is the largest market within West Michigan. It is also where we hold the lowest percent share of the market relative to the other markets within which we operate, and therefore presents great opportunity. In November 2002 we opened a new branch in Grand Rapids, and in Wyoming we opened an expanded branch allowing us to move from a small storefront office. We will continue this expansion focus in 2003 as we expect to open at least three new branches in other desirable locations within our market area. We have begun construction of a new branch in Grandville replacing a storefront location and intend to begin construction in March for a location on the northeast side of Grand Rapids. We anticipate that we will continue to experience growth in our balance sheet and in our earnings due to these expansion opportunities. Financial Condition Summary With the acquisition effective April 1, 2002, the consolidated balance sheet as of December 31, 2002 includes the effect of GBFC. A schedule of the significant GBFC assets and liabilities acquired is contained in Note 2 to the Consolidated Financial Statements. The acquisition was accounted for using the purchase method of accounting. As a result, certain purchase accounting adjustments were required to record the acquired assets and liabilities at market value. The value of the purchase accounting adjustments is being amortized over the respective lives of the varying assets and liabilities. Based on SFAS 142, "Goodwill and Other Intangible Assets", we have recorded intangible assets for the estimated value of core deposit accounts and trust customer accounts acquired in the acquisition. The intangible values represent the present value of the estimated net revenue streams attributed to the respective intangibles. The intangible assets acquired are valued using certain assumptions for alternative 2002 Annual Report 31 Management's Discussion and Analysis of Financial Condition and Results of Operations cost of funds, lives of respective core deposits or trust customers, discount rates and other applicable assumptions. The total of both core deposit intangibles and trust customer intangibles was $3.7 million, and is being amortized on an accelerated basis over 10 years. Amortization of intangibles during 2002 was $392 thousand on a pre-tax basis. The balance of the acquisition price in excess of the fair market value of assets and liabilities acquired, including intangible assets, was recorded as goodwill and totaled $23.9 million. Under SFAS 142, goodwill is defined as an intangible asset with an indefinite useful life, and as such, is not amortized, but is required to be tested annually for impairment of the value. If impaired, an impairment loss must be recorded for the value equal to the excess of the asset's carrying value over its fair value. The amount of goodwill recorded in this transaction compared to the smaller amounts of identified intangible assets and lack of intangibles related to loan and deposit customer lists reflects that the value of GBFC related primarily to the foundation it provides to further build our presence in the Grand Rapids market. The value of this foundation lies with the GBFC workforce, their customer service orientation and their relationships within the community. The amount of the core deposits intangible asset recorded is small compared to the total purchase price because the GBFC deposit portfolio was weighted towards higher interest rate account types. Our total assets were $1.177 billion at December 31, 2002, an increase of $506.4 million from $670.2 million in total assets at December 31, 2001. In addition to the $312.0 million in assets added from the GBFC acquisition, assets grew by $194.4 million during the period. We believe the continued strong asset growth reflects the acceptance of our community banking philosophy in the growing communities we serve. Our asset growth consists primarily of growth in our loan portfolio as we continue to attract new loan customers despite the strong competition from other locally based community banks and larger regional banks. The asset growth was primarily in earning assets of loans and securities, but also included increased cash, premises, and equipment. The increase in total assets was principally funded by strong deposit growth. Deposits grew by $148.6 million during 2002, a 28.0% growth rate, excluding the $246.1 million in deposits added in the GBFC acquisition. Additional borrowings were used to a lesser extent to supplement the funding provided from deposit growth. We attribute the strong deposit growth to our quality customer service, the desire of our customers to bank with a local bank, and convenient accessibility through the expansion of our branch network. Cash and Cash Equivalents Our cash and cash equivalents, which include federal funds sold and short-term investments, were $47.9 million at December 31, 2002, as compared to $34.2 million at December 31, 2001. The increase was a result of having to maintain a higher level of bank balances right at the end of 2002. The higher balances were required to cover uncollected funds deposited in Macatawa Bank's correspondent bank accounts as a result of high customer deposit activity. Securities Our security portfolio is classified as either "available for sale" or "held to maturity". Securities classified as "available for sale" may be sold to meet our liquidity needs. The primary objective of our investing activities is to provide for the safety of the principal invested. Our secondary considerations include earnings, liquidity and decreased overall exposure to changes in interest rates. Securities increased $25.9 million to $90.2 million at December 31, 2002 from $64.3 million at December 31, 2001. In addition to the $11.1 million in securities added from the GBFC acquisition, securities increased by $14.8 million as the result of purchasing additional securities as a means of strengthening our liquidity. We expect continued growth of our securities portfolio generally consistent with the growth of our company in order to maintain appropriate levels of liquidity. Securities Portfolio Year Ended December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------- ------- ------- ------- U.S. Treasury and U.S. Government Agencies $71,867 $55,287 $45,991 State and municipal bonds 18,303 9,029 2,678 $90,170 $64,316 $48,669 Excluding our holdings of the investment portfolio in U.S. Treasury and U.S. Government Agency Securities, we had no investments in securities of any one issuer which exceeded 10.0% of shareholders' equity. 32 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations Schedule of Maturities of Investment Securities and Weighted Average Yields The following is a schedule of maturities and their weighted average yield of each category of investment securities we held at December 31, 2002.
Investments With No (Dollars in thousands) Due Within One Year One to Five Years Five to Ten Years After Ten Years Contractual Maturity ---------------------- ------------------- ------------------ ------------------ ------------------ -------------------- Estimated Estimated Estimated Estimated Estimated Market Average Market Average Market Average Market Average Market Average Value Yield Value Yield Value Yield Value Yield Value Yield --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- U.S. Treasury and U.S. Government Agencies $5,472 5.45% $63,237 5.08% $1,987 4.05% $ 1,170 7.18% -- -- Tax-exempt State and municipal bonds -- -- -- -- 5,796 6.55% 12,587 6.11% -- -- Total $5,472 5.45% $63,237 5.08% $7,783 5.89% $13,757 6.20% -- --
Loan Portfolio Our total loan portfolio increased to $961.0 million at December 31, 2002, from $545.7 million at December 31, 2001. We also had loans held for sale of $18.7 million at December 31, 2002, as compared to $4.6 million at December 31, 2001. In addition to the $246.3 million in loans added from the GBFC acquisition, loans grew by $169.0 million during 2002 continuing our consistent pattern of growth. The majority of loans we make are to small and mid-sized businesses in the form of commercial and commercial real estate loans. Our combined commercial loans accounted for approximately 73.0% of our total portfolio loans at December 31, 2002, compared to 74.0% at December 31, 2001. Our residential real estate loan portfolio, which also includes residential construction loans made to the individual homeowners, comprised approximately 14.0% of portfolio loans. However, our residential loan origination volume is significantly higher, with only a small portion of residential home loans retained for our own portfolio. We sell the majority of fixed-rate obligations and do not retain servicing. We originated for sale $240.8 million in residential mortgages in 2002, $135.6 million in 2001, and $47.0 million in 2000. The lower overall market interest levels experienced during 2002 and 2001 resulted in significantly higher levels of residential refinancing and loan originations during these years as compared to 2000. Our consumer loan portfolio includes both loans secured by personal property, as well as home equity fixed term and line of credit loans. Home equity loans totaled $87.9 million at December 31, 2002, compared to $45.9 million at December 31, 2001. Approximately 89.0% of our home equity loans are underwritten at terms of a loan to value ratio of less than 90.0%, and are considered well collateralized. The types of loans and mix of the GBFC portfolio was very similar to our portfolio and as a result the overall mix of the combined loan portfolio did not change significantly upon acquisition. We anticipate further growth in the loan portfolio due to continuing opportunities within our market area. The following table reflects the composition of our loan portfolio and the corresponding percentage of our total loans represented by each class of loans as of the dates indicated. Loan Portfolio Composition
Year Ended December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------- -------------- -------------- -------------- Amount % Amount % Amount % -------- --- -------- --- -------- --- Commercial real estate $356,310 37% $133,428 25% 79,444 19% Residential real estate 133,843 14% 67,655 12% 60,822 15% Other commercial 341,370 36% 269,993 49% 214,098 52% Consumer 129,515 13% 74,617 14% 56,312 14% Total loans $961,038 100% 545,693 100% 410,676 100% Less: Allowance for loan losses (13,472) (7,699) (5,854) Total loans receivable, net $947,566 $537,994 $404,822
2002 Annual Report 33 Management's Discussion and Analysis of Financial Condition and Results of Operations Maturities and Sensitivities of Loans to Changes in Interest Rates The following table shows the amount of total loans outstanding as of December 31, 2002 which, based on remaining scheduled repayments of principal, are due in the periods indicated. Maturing -------- After One, Within But Within After (Dollars in thousands) One Year Five Years Five Years Total --------------------------- -------- ---------- ---------- -------- Commercial real estate $ 76,313 $265,310 $ 14,680 $356,303 Residential real estate 39,480 35,778 58,643 133,901 Other commercial 199,157 136,738 5,424 341,319 Consumer 22,111 42,226 65,178 129,515 Totals $337,061 $480,052 $143,925 $961,038 Allowance for loan losses (13,472) Total loans receivable, net $947,566 Below is a schedule of the loan amounts maturing or repricing which are classified according to their sensitivity to changes in interest rates at December 31, 2002. Interest Sensitivity (Dollars in thousands) Fixed Rate Variable Rate Total ------------------------------------- ---------- ------------- -------- Due within 3 months $ 37,588 $590,829 $628,417 Due after 3 months, but within 1 year 61,937 2,349 64,286 Due after one but within five years 205,877 26,125 232,002 Due after five years 30,890 5,443 36,333 Total $336,292 $624,746 $961,038 Allowance for loan losses (13,472) Total loans receivable, net $947,566 Nonperforming Assets Nonperforming assets are comprised of nonperforming loans and foreclosed assets. Our nonperforming loans include loans on non-accrual, restructured loans, as well as loans delinquent more than 90 days, but still accruing. Nonperforming loans as of December 31, 2002 totaled $2.8 million compared to $2.4 million at December 31, 2001. One credit comprises approximately one half of the balance in nonperforming loans at the end of 2002. While still paying, this borrower's weak financial condition warranted concern. Therefore, the loan was placed in non-accrual in 2001 and remained in this status throughout 2002. Our loan performance is reviewed regularly by an external loan review team, our own loan officers, and our senior management. When reasonable doubt exists concerning collectibility of interest or principal of one of our loans, that loan is placed in non-accrual status. Any interest previously accrued but not collected at that time is reversed and charged against current earnings. Foreclosed assets include assets acquired in settlement of loans. As of December 31, 2002 foreclosed assets totaled $446,000. There were no foreclosed assets at December 31, 2001. Total nonperforming assets amounted to $3.2 million as of December 31, 2002 and represented 0.28% of total assets, a level well below historical peer averages. The following table shows the composition and amount of our nonperforming assets. December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------------- ------ ------ ---- Nonaccrual loans $2,539 $2,084 $155 Loans 90 days or more delinquent and still accruing 259 298 41 Restructured loans -- -- -- Total nonperforming loans $2,798 2,382 196 Foreclosed assets 446 -- -- Total nonperforming assets $3,244 $2,382 $196 Nonperforming loans to total loans 0.29% 0.43% 0.05% Nonperforming assets to total assets 0.28% 0.36% 0.04% 34 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations Loan Loss Experience The following is a summary of our loan balances at the end of each period and the daily average balances of these loans. It also includes changes in the allowance for loan losses arising from loans charged-off and recoveries on loans previously charged-off, and additions to the allowance which we have expensed.
December 31 (Dollars in thousands) 2002 2001 2000 ----------------------------------------------- -------- -------- -------- Loans: Average daily balance of loans for the year $831,709 $474,318 $347,351 Amount of loans outstanding at end of period 961,038 545,693 410,676 Allowance for loan losses: Balance at beginning of year $ 7,699 $ 5,854 $ 3,995 Balances from GBFC acquisition 3,464 Addition to allowance charged to operations 3,321 2,285 1,931 Loans charged-off: Commercial (1,143) (485) (67) Residential Real Estate -- (1) -- Consumer (128) (27) (20) Recoveries: Commercial 249 63 14 Residential Real Estate -- 1 -- Consumer 10 9 1 Balance at end of year $ 13,472 $ 7,699 $ 5,854 Ratios: Net charge-offs to average loans outstanding 0.12% 0.09% 0.02% Allowance for loan losses to loans outstanding at year end 1.40% 1.41% 1.43%
Allowance for Loan Losses Our allowance for loan losses as of December 31, 2002 was $13.5 million, representing approximately 1.40% of total portfolio loans outstanding, compared to $7.7 million or 1.41% of total loans at December 31, 2001. Our allowance for loan losses is maintained at a level management considers appropriate based upon our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of allowance relies on several key elements, which include specific allowances for identified problem loans, formula allowance for graded loans, and general allocations based on historical trends for pools of similar loan types. Specific allowances are established in cases where senior credit management has identified significant conditions or circumstances related to an individually impaired credit that we believe indicates the probability that a loss has been incurred. This amount is determined by methods prescribed by SFAS No. 114,"Accounting by Creditors for Impairment of a Loan". As of December 31, 2002 and 2001 the specific allowance was $883,000 and $539,000, respectively. The formula allowance is calculated by applying loss factors to outstanding loans based on the internal risk grade of such loans. We use a loan rating method based upon an eight point system. Loans are assigned a loss allocation factor for each loan classification category. The lower the grading assigned to a loan category, the greater the allocation percentage that is applied. Changes in risk grade of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors are based on our loss experience, the banking industry's historical loan loss experience, and may be adjusted for significant factors that, in management's judgement, affect the collectibility of the portfolio as of the analysis date. As of December 31, 2002 and 2001 the formula allowance was $10.1 million and $5.9 million, respectively. Groups of homogeneous loans, such as residential real estate, open- and closed-end consumer loans, etc., receive general allowance allocations based on loss trends. In lieu of an established loan loss trend for Macatawa Bank, we use historical loss trends based on industry experience and peers in determining an adequate allowance for these pools of loans. General economic and business conditions, credit quality trends, collateral values, seasoning of the portfolios and recent loss experience are conditions considered in connection with allocation factors for these similar pools of loans. Since Grand Bank's loan portfolio is seasoned, its loan loss trends are used in determining an adequate allowance for these pools of loans in addition to industry experience and peer information. As of December 31, 2002 and 2001 the general allowance was $1.5 million and $760,000, respectively. During 2002 the allowance for loan losses increased by 30.0% excluding the addition of $3.5 million with the acquisition of GBFC. The 30.0% increase was due primarily to increases in the formula and general allowance allocations. The increases in these allocations were the result of continued strong growth in loans which increased by 31.0% excluding the addition of GBFC loans. Changes in underlying loan performance measures were not significant and did not materially affect the allowance for loan losses in 2002 compared to the prior year. We believed it was prudent to continue increasing the allowance due to the unseasoned nature of our portfolio and current soft economic conditions both on a national basis and locally. Net charge-offs for 2002 totaled $1.0 million compared to $440,000 for 2001. While our net charge-off experience was higher during the current year, our credit losses on loans continue to be low relative to comparable banks. However, we recognize that our loan portfolios remain relatively unseasoned, and no material trend of losses has been established. Given the newness of the portfolios and potential economic weakness, in our judgment, we have provided adequate reserves for loan losses, although there can be no assurance that the allowance for losses on loans will be adequate to cover all losses. We anticipate net charge-offs to increase as our loan portfolio grows and becomes more seasoned. In addition, net charge-offs may increase over levels experienced in 2002 due to the overall weakness in the economy. 2002 Annual Report 35 Management's Discussion and Analysis of Financial Condition and Results of Operations Allocation of the Allowance for Loan Losses The following table shows the allocation of the allowance for loan loss at the dates indicated to the extent specific allocations have been determined relative to particular loans.
Year Ended December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------- ----------------------- ----------------------- ----------------------- % of Each % of Each % of Each Allowance Category to Allowance Category to Allowance Category to Amount Total Loans Amount Total Loans Amount Total Loans --------- ----------- --------- ----------- --------- ----------- Commercial and commercial real estate $11,207 72.6% $6,391 73.9% $3,902 71.5% Residential real estate 326 13.9% 196 12.4% 176 14.8% Consumer 950 13.5% 564 13.7% 435 13.7% Unallocated 989 -- 548 -- 1,341 -- Total $13,472 100.0% $7,699 100.0% $5,854 100.0%
The above allocations are not intended to imply limitations on usage of the allowance. The entire allowance is available for any loan losses without regard to loan type. The allocated portion of the allowance amounted to $12.5 million at December 31, 2002. Of this total, 7.0% related to specific allocations, 81.0% related to formula allocations, and 12.0% related to general allocations. Premises and Equipment Premises and equipment totaled $25.8 million at December 31, 2002, an increase of $10.9 million from December 31, 2001. The increase resulted from costs incurred with construction underway for our new headquarters building, as well as the completion of three new branch locations. The new headquarters location will allow us to consolidate our administration, human resources, trust, loan underwriting and processing, and proof and deposit operations to one location. We expect the new headquarters facility to be completed by April of 2003. The new branch sites allowed us to replace a leased storefront branch site in Wyoming with a full service branch, add a full service branch in a leased location in Byron Center, and add a new location in the Forest Hills area of Grand Rapids. The Byron Center branch opened for service in early April. The Wyoming and Forest Hills branches opened in November. Only $656,000 of the $10.9 million increase in premises and equipment related to the acquisition of GBFC. Deposits Deposits are gathered primarily from the communities we serve through our network of 17 branches. We offer business and consumer checking accounts, regular and money market savings accounts, and certificates of deposits having many options in their terms. Total deposits increased $394.7 million to $920.9 million at December 31, 2002, as compared to $526.2 million at December 31, 2001. In addition to the $246.1 million in deposits added from the GBFC acquisition, deposits grew by $148.6 million during the year. This internal growth in deposits reflects primarily deposits from new customers. We continue to anticipate strong deposit growth based on our focus on quality customer service, the desire of customers to deal with a local bank, convenient accessibility through our growing branch network and our expanded opportunities in the Grand Rapids market as a result of the GBFC acquisition. Noninterest bearing demand accounts comprised approximately 11.0% of total deposits at December 31, 2002, as compared to approximately 12.0% of total deposits at the end of 2001. Interest bearing demand and savings accounts comprised approximately 44.0% of total deposits at December 31, 2002, as compared to 50.0% at the end of last year. Time accounts as a percentage of total deposits were approximately 45.0% at December 31, 2002, and were approximately 38.0% at December 31, 2001. The changes in mix of the portfolio relate primarily to the differences in the mix of the GBFC deposit portfolio compared to our mix at the time of the acquisition. The GBFC portfolio had a higher concentration of time deposits and a lower level of noninterest bearing deposits. We set our deposit pricing to be competitive with other banks in our market area. This has enabled us to increase deposits from new, as well as existing customers, while maintaining a healthy net interest margin. We periodically purchase brokered deposits to supplement funding needs. These are time accounts originated outside of our local market area. Brokered deposits comprised approximately 12.0% of total deposits at December 31, 2002 and approximately 2.0% at December 31, 2001. The GBFC deposit portfolio contained a higher level of brokered deposits to total causing most of the increase in the ratio from the end of 2001 to the end of 2002. We operate in a very competitive environment, competing with other local banks similar in size and with significantly larger regional banks. We monitor rates at other financial institutions in the area to ascertain that our rates are competitive with the market. We also attempt to offer a wide variety of products to meet the needs of our customers. 36 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations Average Daily Deposits The following table sets forth the average deposit balances and the weighted average rates paid thereon.
Average for the Year (Dollars in thousands) 2002 2001 2000 ------------------------------------------- ------------------ ------------------ ------------------ Average Average Average Amount Rate Amount Rate Amount Rate -------- ------- -------- ------- -------- ------- Noninterest bearing demand $ 82,757 -- $ 52,184 -- $ 38,525 -- NOW accounts 118,594 1.1% 55,951 1.8% 45,246 2.6% MMDA/savings 260,206 1.9% 174,933 3.3% 131,069 4.7% Time 328,715 3.6% 176,983 5.8% 123,756 6.4% Total deposits $790,272 2.6% $460,051 3.7% $338,596 4.5%
Maturity Distribution of Time Deposits of $100,000 or More The following table summarizes time deposits in amounts of $100,000 or more by time remaining until maturity as of December 31, 2002: (Dollars in thousands) Amount ------------------------------ -------- Three months or less $ 39,171 Over 3 months through 6 months 46,496 Over 6 months through 1 year 44,260 Over 1 year 127,589 $257,516 Borrowed Funds Borrowed funds consist principally of advances from the Federal Home Loan Bank. Borrowed funds also include federal funds purchased, which are utilized to settle our daily cash letter position with our correspondent banks. Additionally, we have a $10.0 million credit facility available for general corporate needs including contributing capital to the subsidiary banks to enable them to maintain regulatory capital at well-capitalized levels. Borrowed funds totaled $131.8 million at December 31, 2002 including $106.9 million of Federal Home Loan Bank advances, $20.0 million of federal funds purchased and $4.9 million in borrowing on the credit facility. At December 31, 2001 borrowed funds totaled $75.6 million comprised solely of Federal Home Loan Bank advances. Borrowed funds increased during 2002 partially due to the addition of borrowings from the GBFC acquisition, but also due to additional borrowing needs to fund our continued growth in assets. Retained Earnings We had a retained earnings balance of $5.9 million at December 31, 2002 as compared to $3.2 million at December 31, 2001. Retained earnings is comprised of net earnings, less dividends paid to shareholders. During 2002, we paid $2.5 million in cash dividends. A 4% stock dividend was also paid from retained earnings during May of 2002, resulting in the transfer of $4.3 million from retained earnings to our common stock. Results of Operations Summary of Results Net income totaled $9.5 million for 2002 as compared to $5.1 million in 2001, and $3.3 million in 2000. The increase in net income principally reflects growth in our net interest income due to our continuing growth in interest earning assets, but also reflects improvement in noninterest income. Earnings per share on a diluted basis were $1.27 for 2002 compared to $1.07 for 2001 and $.87 for 2000. Diluted earnings per share increased by 19.0% for 2002 compared to 2001 despite a 45.0% increase in shares outstanding for the acquisition of GBFC in the second quarter of 2002. Our net income for 2002 was impacted by the net income earned by Grand Bank. For pro forma information concerning the GBFC acquisition, please refer to Note 2 of the Consolidated Financial Statements. Total revenues, consisting of net interest income and noninterest income, were $41.7 million during 2002, as compared to $25.4 million during 2001, and $18.6 million for 2000. Noninterest expense totaled $24.2 million for 2002, as compared to $15.5 million for 2001, and $12.7 million for 2000. Our federal income tax expense increased substantially during 2001 reflecting our fully taxable status for all of 2001. We initially became taxable during 2000 after utilizing all tax loss carry forwards from 1998 and 1997. 2002 Annual Report 37 Management's Discussion and Analysis of Financial Condition and Results of Operations Analysis of Net Interest Income The following schedule presents, for the periods indicated, information regarding: . our total dollar amount of interest income from average earning assets and the resultant average yields; . our total dollar amount of interest expense on average interest-bearing liabilities and the resultant average cost; . our net interest income; . our interest rate spread; and . our net yield on average earning assets.
For the Years Ended December 31 2002 2001 ------------------------------- ----------------------------- Interest Average Interest Average Average Earned Yield Average Earned Yield (Dollars in thousands) Balance or Paid or Cost Balance or Paid or Cost ---------------------------------------- ---------- -------- ------- -------- -------- ------- Assets Taxable securities $ 65,829 $ 3,477 5.28% $ 49,771 $ 2,921 6.01% Tax-exempt securities (1) 13,315 619 7.21% 6,784 320 7.20% Loans (2) 831,709 52,687 6.27% 474,318 38,904 8.12% Federal funds sold 10,213 175 1.67% 7,864 265 3.33% Short-term investments 544 5 0.94% 1,575 39 2.44% Federal Home Loan Bank stock 4,775 289 5.98% 3,187 236 7.30% Total interest earning assets $ 926,385 $57,252 6.16% $543,499 $42,685 7.82% Noninterest earning assets: Cash and due from banks 32,770 27,377 Other 42,074 13,148 Total assets $1,001,229 $584,024 Liabilities and Shareholders' Equity Deposits: NOW and money market accounts $ 334,510 $ 5,159 1.14% $204,863 $ 5,932 2.90% Savings 24,800 272 1.10% 14,186 200 1.41% IRAs 19,490 876 4.49% 11,834 700 5.91% Time deposits 328,715 11,966 3.64% 176,983 10,177 5.75% Short-term borrowings: Federal funds borrowed 5,392 102 1.87% 1,704 81 4.67% Other borrowings 96,538 4,527 4.62% 65,586 3,837 5.77% Total interest bearing liabilities 809,445 22,902 2.82% 475,156 20,927 4.39% Noninterest bearing liabilities Noninterest bearing demand accounts 82,757 52,184 Other noninterest bearing liabilities 8,503 3,259 Shareholders' equity 100,524 53,425 Total liabilities and Shareholders' equity $1,001,229 $584,024 Net interest income $34,350 $21,758 Net interest spread 3.34% 3.43% Net interest margin 3.69% 3.98% Ratio of interest earning assets to interest bearing liabilities 114.45% 114.38% For the Years Ended December 31 2000 ---------------------------------------- ------------------------------ Interest Average Average Earned Yield or (Dollars in thousands) Balance or Paid or Cost -------- -------- -------- Assets Taxable securities $ 35,459 $ 2,166 6.11% Tax-exempt securities (1) 1,639 86 7.56% Loans (2) 347,351 31,789 9.15% Federal funds sold 1,616 99 6.13% Short-term investments 169 6 3.55% Federal Home Loan Bank stock 2,332 192 8.28% Total interest earning assets $388,566 $34,338 8.85% Noninterest earning assets: Cash and due from banks 18,624 Other 9,897 Total assets $417,087 Liabilities and Shareholders' Equity Deposits: NOW and money market accounts $159,419 $ 6,656 4.17% Savings 9,222 177 1.92% IRAs 7,674 465 6.06% Time deposits 123,756 7,916 6.40% Short-term borrowings: Federal funds borrowed 2,022 131 6.48% Other borrowings 38,857 2,394 6.16% Total interest bearing liabilities 340,950 17,739 5.20% Noninterest bearing liabilities Noninterest bearing demand accounts 38,525 Other noninterest bearing liabilities 1,557 Shareholders' equity 36,055 Total liabilities and Shareholders' equity $417,087 Net interest income $16,599 Net interest spread 3.65% Net interest margin 4.18% Ratio of interest earning assets to interest bearing liabilities 113.97%
(1) Yields are adjusted for tax-exempt interest. (2) Loan fees included in interest income are not material. Nonaccrual loans are included in average loans outstanding. 38 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations Net interest income totaled $34.4 million during 2002, compared to $21.8 million during 2001 and $16.6 million during 2000. The 58.0% increase in net interest income during 2002 was driven entirely by growth in our earning assets. Average earning assets for 2002 totaled $926.4 million, as compared to $543.5 million for 2001. The acquisition of GBFC contributed $210.2 million to this increase in earning assets, however, the remaining $172.7 million was a result of our continued growth. Net interest margin on earning assets was 3.69% for 2002,down from 3.98% for 2001. The contraction in the net interest margin relates primarily to the lower net interest margin that GBFC carried compared to Macatawa, but also reflects a decrease in yield on earning assets resulting from the low and declining interest rate environment during 2002. We have continued to see strong loan growth, but customer preferences during 2002 have been for floating rate loans that bear interest rates on average of 225 basis points lower than fixed rate commercial loans. This preference has altered our mix of variable versus fixed rate commercial loans and has also contributed to the decline in net interest margin. The 31.0% increase in net interest income during 2001 as compared to 2000 was principally due to an increase in average earning assets. The growth in income as a result of our continuing loan growth offset the impacts from contracting net interest margin. Our net interest margin of 3.98% for 2001 was down from 4.18% for 2000. As in 2002, the decrease in our net interest margin during 2001 reflected the impact of the decreasing interest rate environment. Interest rates, as measured by prime rate, fell from 9.50% at January 1, 2001, to 4.75% at December 31, 2001. While the year over year comparisons reflect decreases, there was a 14 basis point increase in net interest margin from the second quarter of 2002 through the fourth quarter. This improvement was accomplished primarily through repositioning of certain assets and liabilities. During the latter half of 2002,approximately $5 million in noninterest earning assets were converted into interest earning assets and lower yielding assets were converted into higher yielding assets by investing some of our short-term investable funds into loans. In addition, growth in noninterest bearing deposits and continued downward repricing of higher costing time deposits contributed to margin improvement in this time period. Anticipated growth in earning assets is expected to continue to increase levels of net interest income, however, net interest margin is not expected to increase until short-term market interest rates begin to increase. Helping margin, maturities in our time deposit portfolio continue to re-price at lower levels, however, to a lesser extent than earlier in the year. Derivative instruments as discussed in Note 16 to the Consolidated Financial Statements have also mitigated some of the decline in net interest margin. Rate/Volume Analysis of Net Interest Income The following schedule presents the dollar amount of changes in interest income and interest expense for major components of earning assets and interest-bearing liabilities, distinguishing between changes related to outstanding balances and changes due to interest rates.
Year Ended December 31 (Dollars in thousands) 2002 vs 2001 2001 vs 2000 ---------------------- Increase (Decrease) Due to Increase (Decrease) Due to ---------------------------- -------------------------- Volume Rate Total Volume Rate Total ------- -------- ------- ------- ------- ------ Interest Income Taxable securities $ 870 $ (314) $ 556 $ 755 $ -- $ 755 Tax-exempt securities 304 (5) 299 270 (36) 234 Loans 24,188 (10,405) 13,783 12,340 (5,225) 7,115 Fed funds sold 64 (154) (90) 338 (172) 166 Short term investments (16) (18) (34) 34 (1) 33 FHLB stock 102 (49) 53 70 (26) 44 Total interest income $25,512 $(10,945) $14,567 $13,807 $(5,460) $8,347 Interest Expense NOWs and MMDAs $ 2,745 $ (3,518) $ (773) $ 1,847 $(2,571) $ (724) Savings 124 (52) 72 96 (73) 23 IRAs 374 (198) 176 253 (18) 235 Time deposits 6,483 (4,694) 1,789 3,323 (1,062) 2,261 Fed funds purchased 93 (72) 21 (20) (30) (50) Other borrowings 1,557 (867) 690 1,663 (220) 1,443 Total interest expense 11,376 (9,401) 1,975 7,162 (3,974) 3,188 Net interest income $14,136 $ (1,544) $12,592 $ 6,645 $(1,486) $5,159
2002 Annual Report 39 Management's Discussion and Analysis of Financial Condition and Results of Operations Composition of Average Interest Earning Assets and Interest Bearing Liabilities Year Ended December 31 (Dollars in thousands) 2002 2001 2000 ------------------------------------ -------- -------- -------- As a Percent of Average Interest Earning Assets Loans 89.78% 87.27% 89.39% Other earning assets 10.22% 12.73% 10.61% Average interest earning assets $926,385 $543,499 $388,566 As a Percent of Average Interest Bearing Liabilities Savings, MMS, IRA, and NOW accounts 46.80% 48.59% 51.71% Time deposits 40.61% 37.25% 36.30% Other borrowings 12.59% 14.16% 11.99% Average Interest Bearing Liabilities $809,445 $475,156 $340,950 Earning asset ratio 114.45% 114.38% 113.97% Provision for Loan Losses Our provision for loan losses for 2002 was $3.3 million as compared to $2.3 million for 2001 and approximately $1.9 million for 2000. Some of the increase in provision was due to the increase in charge-offs in 2002 compared to 2001. However, the amount of the loan loss provision in all periods is a byproduct of establishing our allowance for loan losses at levels deemed necessary in our methodology for determining the adequacy of the allowance. For more information about our allowance for loan losses and our methodology for establishing its level, see the earlier discussion under Financial Condition. Along with other financial institutions, management shares a concern for the possible continuing weak economic conditions. Should the economic climate remain soft, borrowers may experience more difficulty in making loan payments, and the level of non-performing loans, charge-offs, and delinquencies could rise and require further increases in the provision. While we sustained higher loan charge-offs during 2002 as compared to prior years, our losses as a percent of average loans totaled only 12 basis points, a level far below historic peer averages. Noninterest Income Noninterest income totaled $7.3 million during 2002, as compared to $3.7 million in 2001, and $2.1 million for 2000. The level of noninterest income for 2002 was up 99.0% over 2001. All components of noninterest income increased compared to 2001. The increased deposit service charge income in 2002 is reflective of our expanded customer account base. Our mortgage banking function was well-positioned to capitalize on the favorable mortgage refinance environment caused by low interest rates during 2002 and achieved high loan sales volume resulting in gains of $2.4 million for the year. While mortgage interest rates remain at low levels, it is expected that refinance activity will slow down resulting in a possible decline in our loan sales volume during 2003. Revenues from trust services grew to $2.1 million for 2002 compared to $659,000 for 2001. Trust fees are, to a great extent, based on the underlying values of trust assets managed. Despite a generally downward trend in market valuation of securities during 2002, trust fees increased as compared to the prior year due to our success in gaining new trust customers and the addition of Grand Bank's trust services. We believe trust fee income will continue to increase as the amount of trust assets under our management increases. Service charges and fees increased by $768,000 during 2001 as compared to 2000 and reflected the growth in our customer base. Gain on sale of loans increased by $710,000 over the 2000 level due to the favorable mortgage refinance environment in 2001 compared to 2000. Trust fees increased in 2001 compared to 2000 due to the increase in the amount of trust assets under management. The following table details major components of noninterest income for the years 2002, 2001, and 2000. Noninterest Income Year Ended December 31 (Dollars in thousands) 2002 2001 2000 --------------------------- ------ ------ ------ Deposit service charges $2,247 $1,912 $1,144 Net gains on sales of loans 2,382 1,071 361 Trust fees 2,118 659 531 Other 576 41 16 Total noninterest income $7,323 $3,683 $2,052 Net Gains on the Sale of Residential Real Estate Mortgage Loans Year Ended December 31 (Dollars in thousands) 2002 2001 2000 ----------------------------------------------- -------- -------- ------- Real estate mortgage loan originations for sale $240,819 $135,615 $47,007 Real estate mortgage loan sales 229,047 132,115 47,368 Net gains on the sale of real estate mortgage loans $ 2,382 $ 1,071 $ 361 Net gains as a percent of real estate mortgage loan sales 1.04% 0.81% .76% We sell the majority of the fixed-rate mortgage loans we originate. We do not retain the servicing rights for the loans we sell. Noninterest Expense Noninterest expense totaled $24.2 million for 2002, as compared to $15.5 million for 2001, and $12.7 million for 2000. Salaries and benefits increased by $4.5 million for 2002 compared to the prior year and was the primary category of increase in noninterest expense. Most of this increase related to the addition of the Grand Bank workforce, however, our continued growth required additional staff as compared to 2001. The staff growth reflected the expansion required to handle the growing lending portfolios and operational personnel necessary to support increased customer activity. Other increases included occupancy and equipment expense, data 40 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations processing, and other support related expenses, such as courier, telephone, postage, and outside services, all of which increased partially due to the GBFC acquisition. All of these costs relate to customer activity and branch infrastructure, and increased as a result of new customer activity being generated. Total noninterest expense increased by 56.0% for 2002 whereas net interest income and noninterest income in total grew by 64.0%. The greater revenue growth versus expense growth resulted in an improved efficiency ratio of 58.0% for 2002 as compared to 61.1% for 2001. This improvement was a direct result of synergies achieved in the GBFC acquisition as well as continued better capacity usage of the branch network and operations. During 2002 we opened two new branches and moved from a small leased location to a new expanded branch location. These new branches are in premier locations and have already experienced strong growth in new customer relationships. We plan to continue this expansion focus primarily in Grand Rapids where we hold the lowest share of the market compared to others we serve. During 2003 we plan to open at least three new branches in strategic locations within our market area. Although these new locations increase occupancy and equipment costs, we expect the benefits from the customer relationship growth opportunities they offer will outweigh the additional costs. We integrated the systems and operations of Grand Bank into ours during the second quarter of 2002. By utilizing the same systems at both Macatawa Bank and Grand Bank, we realized operational efficiencies, primarily in data processing, during the year. On January 1, 2003 we completed the final step of the integration with the name change of Grand Bank to Macatawa Bank by merging the two bank charters into one. This charter merger allows for more operational efficiencies and simplifies service to our customers. Increases in salaries and benefits during 2001 reflected the addition of new lending staff, lending and operations support staff, as well as additional branch staff for new locations. Other expense increases in 2001 were principally due to supporting our expanding customer base. These included advertising, data processing, legal and professional service fees, postage, and office supply expenses. The following table details major components of noninterest expense for the years of 2002, 2001, and 2000. Noninterest Expense Year Ended December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------- ------- ------- ------- Salaries and employee benefits $12,838 $ 8,359 $ 6,865 Occupancy and equipment 1,861 1,230 1,094 Furniture and equipment expense 2,161 1,580 1,244 Legal and professional fees 617 359 248 Advertising 722 537 366 Supplies 486 392 348 Data processing fees 829 715 561 Other operating expenses 4,673 2,371 1,946 Total noninterest expense $24,187 $15,543 $12,672 Liquidity and Capital Resources Equity Capital. In conjunction with the acquisition of GBFC we issued 2,472,000 shares of stock in exchange for all of the outstanding stock of GBFC. GBFC's regulatory capital ratios were at similar levels to ours upon acquisition and as a result, had minimal impact on our combined ratios of regulatory capital. At December 31,2002, our Tier I Capital as a percent of average assets was 7.6%, and our total capital to risk-weighted assets was 9.9%, as compared to 10.1% and 12.9% respectively at December 31,2001. The decrease in these regulatory capital ratios reflects our continued internal growth in assets. Additional capital will be necessary within the next year if our growth continues at its current pace. Alternative capital sources include additional common stock offerings, trust preferred securities offerings and subordinated debt. Macatawa Bank Corporation was categorized as "adequately capitalized" for regulatory capital purposes while Macatawa Bank and Grand Bank were categorized as "well-capitalized" as of December 31, 2002. During the second quarter of 2001, we completed a common stock offering, issuing 1,610,000 additional shares of common stock, resulting in net proceeds to us of $23.7 million after offering commissions and expenses. We used a portion of the proceeds from the capital offering to pay off some borrowings, as well as to contribute additional capital to Macatawa Bank to maintain regulatory capital levels. 2002 Annual Report 41 Management's Discussion and Analysis of Financial Condition and Results of Operations We declared our first cash dividend during the fourth quarter of 2000 in the amount of $.07 per share. We subsequently paid a quarterly cash dividend of $.07 per share during 2001. During the fourth quarter of 2001, the cash dividend was increased to $.08 per share and had continued at this level through the third quarter of 2002. In the fourth quarter of 2002 we increased the cash dividend by 25.0% to $.10. It is anticipated that we will continue to pay quarterly cash dividends in the future. On May 8, 2002, we distributed a 4% stock dividend to our shareholders. This was the second consecutive annual stock dividend, and was an increase over the 3.0% dividend paid in May of 2001. One stock repurchase transaction in the amount of 115,000 shares took place during the third quarter of 2002. Further stock repurchase activity is not anticipated in the foreseeable future. The following table shows various capital ratios as of December 31, 2002. Capital Resources Tier I Tier I Total Leverage Capital Risk-Based Ratio Ratio Capital Ratio -------- ------- ------------- Minimum regulatory requirement for capital adequacy 4.0% 4.0% 8.0% Well capitalized regulatory level 5.0% 6.0% 10.0% Consolidated 7.6% 8.6% 9.9% Macatawa Bank 7.7% 8.8% 10.0% Grand Bank 7.1% 7.8% 10.7% Liquidity. The liquidity of a financial institution reflects its ability to provide funds to meet loan requests, to accommodate possible outflows of deposits and to take advantage of interest rate market opportunities. Our sources of liquidity include loan payments by our borrowers, maturity and sales of our securities available for sale, growth of our deposits and deposit equivalents, federal funds sold, our borrowings from the Federal Home Loan Bank, and our issuance of common stock. Liquidity management involves the ability to meet the cash flow requirements of our customers. Our customers may be either borrowers with credit needs or depositors wanting to withdraw funds. We feel our liquidity position is sufficient to meet these needs. 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. Macatawa Bank and Grand Bank have only limited agricultural-related loan assets, and therefore have no significant exposure to changes in commodity prices. As a result, our market risk exposure is mainly comprised of our sensitivity to interest rate risk. Our balance sheet has sensitivity, in various categories of assets and liabilities, to changes in prevailing rates in the U.S. for prime rate, mortgage rates, U.S. Treasury rates and various money market indexes. Our asset/liability management process aids us in providing liquidity while maintaining a balance between interest earning assets and interest bearing liabilities. We use two interest rate risk measurement techniques in our interest rate risk management. The first is static gap analysis. This measures the difference between the dollar amounts of interest sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to our net interest margin during periods of changing market interest rates. 42 Macatawa Bank Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations The following table illustrates our interest rate repricing gaps for selected maturity periods at December 31, 2002.
Static Gap Analysis (Dollars in thousands) 0 to 3 Months 4 to 12 Months 1 to 5 Years Over 5 Years Total ------------------------------------------ ------------- -------------- ------------ ------------ ---------- Assets Loans-fixed $ 37,588 $ 61,937 $205,877 $ 30,890 $ 336,292 Loans-variable 590,829 2,349 26,125 5,443 624,746 Taxable securities 189 5,271 63,236 3,171 71,867 Tax exempt securities -- -- -- 18,303 18,303 Short term investments -- -- -- -- -- Fed funds sold -- -- -- -- -- Other securities -- -- -- 5,391 5,391 Loan loss reserve -- -- -- -- (13,472) Cash & due from banks -- -- -- -- 47,874 Acquisition intangibles -- -- -- -- 27,186 Loans held for sale -- -- -- -- 18,726 Fixed assets -- -- -- -- 25,751 Other assets -- -- -- -- 13,919 Total assets $628,606 $ 69,557 $295,238 $ 63,198 $1,176,583 Liabilities Time deposits $ 58,928 $143,926 $203,957 $ 3,844 $ 410,655 Savings 28,730 -- -- -- 28,730 Other interest bearing deposits 378,458 -- -- -- 378,458 Other borrowings 48,936 9,454 40,429 33,014 131,833 Noninterest bearing deposits -- -- -- -- 103,030 Other liabilities & equity -- -- -- -- 123,877 Total liabilities & equity $515,052 $153,380 $244,386 $ 36,858 $1,176,583 Period gap $113,554 $(83,823) $ 50,852 $ 26,340 Cumulative gap $113,554 $ 29,731 $ 80,583 $106,923 Cumulative gap/total assets 9.65% 2.53% 6.85% 9.09%
The above table shows that total assets maturing or repricing within one year exceed liabilities maturing or repricing within one year by $29.7 million indicating that we are asset sensitive in this time horizon. However, the repricing and cash flows of various categories of assets and liabilities are subject to competitive and other influences that are beyond our control. Gap analysis also does not reflect the magnitude of interest rate changes on net interest income as a result of the various assets and liabilities shown as repriceable within twelve months. As a result, various assets and liabilities indicated above as maturing or repricing within a stated period may, in fact, mature or reprice in other periods or at different volumes. The second interest rate risk measurement used is simulation analysis. We use a computer-based earnings simulation model to estimate the effects of various interest rate environments on the balance sheet structure and net interest income. 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 repayment speeds on various loan and investment assets, cash flows and maturities of interest-sensitive assets, cash flows and maturities of interest-sensitive liabilities, and changes in market conditions impacting loan and deposit pricing. We also include pricing caps and floors on discretionary priced liability products which limit both how low various checking and savings products could go under declining interest rates, as well as how high they could go in a rising interest rate environment. These caps and floors reflect our pricing philosophy in response to changing interest rates. In running the simulation model, we first forecast the next twelve months of net interest income under an assumed environment of constant market interest rates. Next, immediate and parallel interest rate shocks are constructed in the model. 2002 Annual Report 43 Management's Discussion and Analysis of Financial Condition and Results of Operations These rate shocks reflect changes of equal magnitude to all market interest rates. The next twelve months of net interest income are then forecast under each of the rate shock scenarios. The resulting change in net interest income is an indication of the sensitivity of our earnings to directional changes in market interest rates. This model is based solely on parallel changes in market rates and does not reflect the levels of interest rate risk that may arise from other factors such as changes in the spreads between key market rates or in the shape of the Treasury yield curve. The net interest income sensitivity is monitored by the Asset/Liability Committee which evaluates the results in conjunction with acceptable interest rate risk parameters. The quarterly rate simulation results are reported to the board of directors. The simulation also measures the change in the Economic Value of Equity. This represents the change in the net present value of our assets and liabilities under the same parallel shifts in interest rates, as calculated by discounting the estimated future cash flows using a market-based discount rate. Cash flow estimates incorporate anticipated changes in prepayment speeds of loans and securities. The following table shows the suggested impact on net interest income over the next twelve months and Economic Value of Equity based on our balance sheet as of December 31,2002. Changes in Economic Value of Equity and Net Interest Income Economic Value of Equity Percent Net Interest Percent (Dollars in thousands) (EVE) Change Income Change ------------------------ -------------- ------- ------------ ------- Change in Interest Rates 200 basis point rise $112,158 1.9% $48,944 13.6% 100 basis point rise 112,557 2.2% 45,999 6.8% Base-rate scenario 110,093 -- 43,077 -- 100 basis point decline 108,504 (1.4%) 40,176 (6.7)% 200 basis point decline 110,783 0.6% 35,434 (17.7)% The net interest income fluctuations in the above table reiterate our asset sensitive position identified by the gap table. The acquisition of GBFC did not significantly impact our interest rate risk profile as Grand Bank's asset and liability make-up was similar to ours. If interest rates were to increase, this analysis suggests that we are well positioned for improvements in net interest income. Further, our balanced sensitivity in time horizons beyond one year results in little fluctuation in economic value of equity in the various rate shock scenarios. 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, and client preferences. Recent Regulatory Developments Federal legislation (the Gramm-Leach-Bliley Act of 1999) eliminates many federal and state law barriers to affiliations among banks and other financial services providers. The legislation, which took effect March 11, 2000, establishes a statutory framework pursuant to which full affiliations can occur between banks and securities firms, insurance companies, and other financial companies. The legislation provides some degree of flexibility in structuring these new affiliations, although certain activities may only be conducted through a holding company structure. The legislation preserves the role of the Board of Governors of the Federal Reserve System as the umbrella supervisor for holding companies, but incorporates a system of functional regulation pursuant to which the various federal and state financial supervisors will continue to regulate the activities traditionally within their jurisdictions. The legislation specifies that banks may not participate in the new affiliations unless they are well-capitalized, well-managed and maintain a rating under the Community Reinvestment Act of 1977 of at least satisfactory among all affiliates. We have elected to become a financial holding company pursuant to Title I of the Gramm-Leach-Bliley Act, effective January 9, 2002. At the present time, we have no plans to engage in any of the expanded activities permitted under the new regulations. Forward-Looking Statements This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995, and are including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies, and expectations are generally identifiable by use of the words believe, expect, intend, anticipate, estimate, project, may or similar expressions. The presentation and discussion of the provision and allowance for loan losses, statements concerning future profitability or future growth or increases, are examples of inherently forward-looking statements in that they involve judgements and statements of belief as to the outcome of future events. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on our operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area and accounting principles, policies, and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning us and our business, including additional factors that could materially affect our financial results, is included in our filings with the Securities and Exchange Commission. 44 Macatawa Bank Corporation Report of Independent Auditors Board of Directors and Shareholders Macatawa Bank Corporation Zeeland, Michigan [LOGO] CROWE CHIZEK We have audited the accompanying consolidated balance sheets of Macatawa Bank Corporation as of December 31,2002 and 2001 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, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 Macatawa Bank Corporation at December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. /s/ Crowe, Chizek and Company LLP --------------------------------- Crowe, Chizek and Company LLP Grand Rapids, Michigan January 24, 2003 2002 Annual Report 45 Consolidated Balance Sheets
December 31 (Dollars in thousands) 2002 2001 --------------------------------------------------------------------- ---------- -------- Assets Cash and due from banks $ 47,874 $ 29,680 Federal funds sold -- 4,000 Short term investments -- 518 Total cash and cash equivalents 47,874 34,198 Securities available for sale, at fair value 86,109 63,606 Securities held to maturity (fair value 2002 - $4,140;2001 - $649) 4,061 710 Federal Home Loan Bank stock 5,391 3,782 Loans held for sale 18,726 4,571 Total loans 961,038 545,693 Allowance for loan losses (13,472) (7,699) 947,566 537,994 Premises and equipment - net 25,751 14,850 Accrued interest receivable 4,411 3,247 Goodwill 23,915 -- Intangible assets 3,271 -- Other assets 9,508 7,245 Total assets $1,176,583 $670,203 Liabilities and Shareholders' Equity Deposits Noninterest-bearing $ 103,030 $ 60,829 Interest-bearing 817,843 465,363 Total 920,873 526,192 Federal Home Loan Bank advances 106,897 75,638 Other borrowings 4,936 -- Federal funds purchased 20,000 -- Accrued expenses and other liabilities 9,903 1,871 Total liabilities $1,062,609 $603,701 Shareholders' equity Preferred stock, no par value, 500,000 shares authorized; no shares issued and outstanding Common stock, no par value, 20,000,000 shares authorized; 7,891,502 and 5,307,201 shares issued and outstanding at December 31,2002 and 2001, respectively 105,201 62,334 Retained earnings 5,931 3,180 Accumulated other comprehensive income 2,842 988 Total shareholders' equity 113,974 66,502 Total liabilities and shareholders' equity $1,176,583 $670,203
See accompanying notes to consolidated financial statements. 46 Macatawa Bank Corporation Consolidated Statements of Income
December 31 (Dollars in thousands) 2002 2001 2000 --------------------------------------------------- ------- ------- ------- Interest income Loans, including fees $52,687 $38,903 $31,787 Securities 4,565 3,782 2,551 Total interest income 57,252 42,685 34,338 Interest expense Deposits 18,273 17,009 15,213 Other 4,629 3,918 2,526 Total interest expense 22,902 20,927 17,739 Net interest income 34,350 21,758 16,599 Provision for loan losses 3,321 2,285 1,931 Net interest income after provision for loan losses 31,029 19,473 14,668 Noninterest income Service charges and fees 2,247 1,912 1,144 Mortgage production revenue 2,382 1,071 361 Trust fees 2,118 659 531 Other 576 41 16 Total noninterest income 7,323 3,683 2,052 Noninterest expense Salaries and benefits 12,838 8,359 6,865 Occupancy expense of premises 1,861 1,230 1,094 Furniture and equipment expense 2,161 1,580 1,244 Legal and professional fees 617 359 248 Advertising 722 537 366 Supplies 486 392 348 Data processing fees 829 715 561 Other 4,673 2,371 1,946 Total noninterest expense 24,187 15,543 12,672 Income before income tax expense 14,165 7,613 4,048 Income tax expense 4,652 2,497 699 Net income $ 9,513 $ 5,116 $ 3,349 Basic earnings per share $ 1.29 $ 1.08 $ 0.87 Diluted earnings per share $ 1.27 $ 1.07 $ 0.87
See accompanying notes to consolidated financial statements. 2002 Annual Report 47 Consolidated Statements of Changes in Shareholders' Equity
Accumulated Other Retained Comprehensive Total Common Earnings Income Shareholders' Years Ended December 31 (Dollars in thousands) Stock (Deficit) (Loss) Equity ------------------------------------------------------------------------- -------- --------- ------------- ------------- Balance, January 1, 2000 $ 36,883 $(1,961) $ (396) $ 34,526 Net income -- 3,349 -- 3,349 Other comprehensive income (loss): Net change in unrealized gain (loss) on securities available for sale, net of tax of $256 -- -- 497 497 Comprehensive income 3,846 Common stock issued upon exercise of stock options (750 shares) 7 -- -- 7 Cash dividends at $.07 per share -- (251) -- (251) Balance, December 31, 2000 36,890 1,137 101 38,128 Net income -- 5,116 -- 5,116 Other comprehensive income (loss): Net change in unrealized gain (loss) on securities available for sale, net of tax of $457 -- -- 887 887 Comprehensive income 6,003 Proceeds from sale of 1,610,000 shares of common stock, net of offering costs 23,677 -- -- 23,677 Issued 107,474 shares in payment of 3% stock dividend 1,763 (1,766) -- (3) Common stock issued upon exercise of stock options (412 shares) 4 -- -- 4 Cash dividends at $.28 per share -- (1,307) -- (1,307) Balance, December 31, 2001 62,334 3,180 988 66,502 Net income -- 9,513 -- 9,513 Other comprehensive income (loss): Net change in unrealized gain (loss) on derivative instruments, net of tax of $338 -- -- 656 656 Net change in unrealized gain (loss) on securities available for sale, net of tax of $617 -- -- 1,198 1,198 Comprehensive income 11,367 Issued 2,472,015 shares for acquisition of GBFC, adjusted for stock dividend 39,817 -- -- 39,817 Conversion of GBFC stock options 987 -- -- 987 Repurchase of 115,000 shares (2,300) -- -- (2,300) Issued 212,355 shares in payment of 4% stock dividend 4,270 (4,277) -- (7) Common stock issued upon exercise of stock options (14,931 shares) 93 -- -- 93 Cash dividends at $.34 per share -- (2,485) -- (2,485) Balance, December 31, 2002 $105,201 $ 5,931 $2,842 $113,974
See accompanying notes to consolidated financial statements. 48 Macatawa Bank Corporation Consolidated Statements of Cash Flows
Years Ended December 31 (Dollars in thousands) 2002 2001 2000 ---------------------------------------------------------------------------- --------- --------- --------- Cash flows from operating activities Net income $ 9,513 $ 5,116 $ 3,349 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 2,368 1,473 1,232 Provision for loan losses 3,321 2,285 1,931 Origination of loans for sale (240,819) (135,615) (47,007) Proceeds from sales of loans originated for sale 229,047 132,115 47,368 Gain on sales of loans (2,382) (1,071) (362) Net change in Accrued interest receivable and other assets 1,708 (5,289) (3,010) Accrued expenses and other liabilities 2,086 (454) 810 Net cash from operating activities 4,842 (1,440) 4,311 Cash flows from investing activities Loan originations and payments, net (166,549) (135,457) (125,373) Purchase of FHLB stock (815) (1,232) (238) Purchases of securities held to maturity -- (710) -- Purchases of securities available for sale (29,083) (46,690) (19,598) Maturities and calls of securities available for sale 13,584 33,030 -- Principal paydowns on investments 2,469 -- -- Cash received from acquisition of GBFC 21,390 -- -- Additions to premises and equipment (12,109) (3,992) (3,534) Net cash from investing activities (171,113) (155,051) (148,743) Cash flows from financing activities Net increase in deposits 148,621 127,575 119,227 Net increase (decrease) in short-term borrowings 20,000 (6,200) 6,200 Proceeds from other borrowings 4,936 -- 4,000 Repayments on other borrowings -- (4,000) -- Proceeds from FHLB advances 29,328 35,166 56,000 Repayments on FHLB advances (18,239) (10,528) (35,000) Fractional shares purchased (7) (3) -- Cash dividends paid (2,485) (1,307) (251) Shares repurchased (2,300) -- -- Proceeds from sale of stock and exercises of options 93 23,681 7 Net cash from financing activities 179,947 164,384 150,183
See accompanying notes to consolidated financial statements (Continued) 2002 Annual Report 49 Consolidated Statements of Cash Flows (Continued)
Years Ended December 31 (Dollars in thousands) 2002 2001 2000 ---------------------------------------------------------------------------- --------- ------- ------- Net change in cash and cash equivalents 13,676 7,893 5,751 Beginning cash and cash equivalents 34,198 26,305 20,554 Ending cash and cash equivalents $ 47,874 $34,198 $26,305 Supplemental disclosures of cash flow information Cash paid during the period for Interest $ 22,525 $20,984 $17,100 Income taxes 5,450 3,178 1,975 Noncash investing and financing activities: GBFC acquisition: Securities acquired (including FHLB stock) 11,864 Loans acquired 246,344 Premises and equipment acquired 656 Acquisition intangibles recorded 27,578 Other assets acquired 4,142 Deposits assumed 246,060 Borrowings assumed 20,170 Other liabilities assumed 4,940 Value of common stock issued and converted stock options 40,804
See accompanying notes to consolidated financial statements. 50 Macatawa Bank Corporation Notes to Consolidated Financial Statements NOTE 1 -- Summary of Significant Accounting Policies Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Macatawa Bank,and its wholly-owned subsidiary, Macatawa Bank Mortgage Company; Grand Bank, and its wholly-owned subsidiary, Grand Bank Mortgage Company; and Macatawa Bank Brokerage Services, after elimination of intercompany accounts and transactions. Nature of Operations. Macatawa Bank Corporation (the "Company") became the bank holding company for Macatawa Bank on February 23, 1998. Macatawa Bank commenced operations on November 25, 1997. The Company completed an underwritten initial public offering of common stock on April 7,1998,which resulted in net proceeds to the Company of $14.1 million. On April 30,1999,the Company had another common stock offering and sold 1,188,043 shares,raising $14.6 million. The Company completed an additional common stock offering in July 2001 and sold 1,610,000 shares, raising $23.6 million. Grand Bank became a wholly-owned subsidiary effective April 1, 2002 upon the completion of the acquisition of Grand Bank Financial Corporation (GBFC), and its results are included in the consolidated statements of income since this effective date. Both Macatawa Bank and Grand Bank are Michigan chartered banks with depository accounts insured by the Federal Deposit Insurance Corporation. The banks operate seventeen branch offices and three lending and operational service facilities, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County,and northern Allegan County, Michigan. Effective January 1, 2003 Grand Bank was merged into Macatawa Bank with the combined bank named Macatawa Bank. Macatawa Bank Mortgage Company and Grand Bank Mortgage Company originate and sell residential mortgage loans into the secondary market on a servicing released basis. Macatawa Bank Brokerage Services was formed in October 2001 and gained approval in June 2002 from NASD to commence operations as a broker/dealer. Macatawa Bank Brokerage Services provides various brokerage services including discount brokerage, personal financial planning and consultation regarding individual stocks and mutual funds. The Company elected to become a financial holding company pursuant to Title I of the Gramm-Leach-Bliley Act, effective January 9, 2002. At the present time, the Company has no plans to engage in any of the expanded activities permitted under the new regulations. 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 losses, the fair value of intangible assets and the fair values of financial instruments are particularly subject to change. Concentration of Credit Risk. Loans are granted to, and deposits are obtained from, customers primarily in the western Michigan area as described above. Substantially all loans are secured by specific items of collateral,including residential real estate, commercial real estate, commercial assets and consumer assets. Other financial instruments,which potentially subject the Company to concentrations of credit risk, include deposit accounts in other financial institutions. Cash Flow Reporting. Cash and cash equivalents include cash on hand, demand deposits with other financial institutions and short-term securities (securities with maturities of equal to or less than 90 days 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 are classified as held to maturity and 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 their fair value and the related unrealized holding gain or loss is reported in other comprehensive income. Interest income includes amortization of purchase premium or discount. Gains and losses on sales are based on the amortized cost of the security sold. Securities are written down to fair value when a decline in fair value is not temporary. Loans. Loans are reported at the principal balance outstanding, net of the allowance for loan losses,and charge-offs. Loans held for sale are reported at the lower of cost or market, on an aggregate basis. Loans are sold servicing released, therefore no mortgage servicing right assets are established. 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 is impaired or payments are past due over 90 days (180 days for residential mortgages). Payments received on such loans are reported as principal reductions. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and recoveries, and decreased by charge-offs. Management estimates the allowance balance required based on known and inherent risks in the portfolio, economic conditions and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment,should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Loan impairment is reported when full payment under the loan terms is not expected. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported,net, at the present value of estimated future cash flows using the loan's 2002 Annual Report 51 Notes to Consolidated Financial Statements existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans are evaluated for impairment when payments are delayed, typically 90 days or more,or when the internal grading system indicates a doubtful classification. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans,are collectively evaluated for impairment, and accordingly,they are not separately identified for impairment disclosures. Foreclosed Assets. Assets acquired through or instead of loan 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. The Company held $388,000 in foreclosed assets at December 31, 2002 and $66,000 in foreclosed assets at December 31, 2001. Premises and Equipment. Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 40 years. Furniture,fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from three to five years. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. These assets are reviewed for impairment when events indicate the carrying amount may not be recoverable. Income Taxes. Income tax expense is the sum 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 consequences of 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. 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 do 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 net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements. Stock Compensation. Employee compensation expense under stock option plans is reported using the intrinsic value method. No compensation cost related to stock options was recognized during 2002, 2001 or 2000, 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. Had compensation cost for stock options been measured using the fair value method, net income and basic and diluted earnings per share would have been the pro forma amounts indicated below (dollars in thousands except per share data). The pro forma effect may increase in the future if more options are granted. 2002 2001 2000 ------ ------ ------ Net income as reported $9,513 $5,116 $3,349 Pro forma net income 9,299 5,080 3,280 Basic earnings per share as reported 1.29 1.08 .87 Pro forma basic earnings per share 1.26 1.07 .86 Diluted earnings per share as reported 1.27 1.07 .87 Pro forma diluted earnings per share 1.25 1.06 .85 Weighted-average fair value of options granted during the period 3.48 4.84 2.38 The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of grant date. 2002 2001 2000 ------- ------- ------- Risk-free interest rate 4.83% 4.78% 5.26% Expected option life 7 years 7 years 7 years Expected stock price volatility 7.29% 21.58% 26.87% Dividend yield 1.78% 1.79% 2.00% 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 and unrealized gains and losses on cash flow hedges which are also recognized as separate components of equity. Segment Reporting. The Company, through the branch network of the Banks, provides a broad range of financial services to individuals and companies in western Michigan. These services include demand, time and savings deposits, lending, ATM processing, cash management, and trust services. While the Company's management team monitors the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's banking operations are considered by management to be aggregated in one reportable operating segment. 52 Macatawa Bank Corporation Notes to Consolidated Financial Statements Off Balance Sheet Financial Instruments. Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby 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 financial instruments are recorded when they are funded. Loss 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. Derivative Instruments and Hedging Activities. All derivative instruments are recorded at their fair values. If derivative instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in other comprehensive income and reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of hedges are reflected in income currently. Goodwill. Goodwill results from prior business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Acquisition Intangibles. Acquisition intangibles consist of core deposit and acquired customer relationship intangible assets arising from acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives. Newly Issued But Not Yet Effective Accounting Standards. New accounting standards on asset retirement obligations, restructuring activities and exit costs, operating leases, and early extinguishment of debt were issued in 2002. Management determined that when the new accounting standards are adopted in 2003 they will not have a material impact on the Company's financial condition or results of operations. Dividend Restriction. Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to shareholders. Reclassifications. Some items in the prior year financial statements were reclassified to conform to the current presentation. NOTE 2 -- Acquisition On April 1, 2002, the Company completed the acquisition of Grand Bank Financial Corporation ("GBFC"), a commercial bank headquartered in Grand Rapids, Michigan. Under the terms of this transaction, the Company acquired all of the outstanding stock of GBFC in exchange for approximately 2.5 million common shares, adjusted for the 4.0%stock dividend paid in May 2002. The value of the common shares issued was determined using the Company's quoted market price per share at the time the terms of the acquisition agreement were agreed to and announced. Further, options to acquire GBFC stock were converted to options to acquire Company stock. The value of these options for purposes of determining the total cost to the Company for the acquisition was approximately $1.0 million. Accordingly, the total cost of the transaction considering common stock and converted options was approximately $40.8 million. The acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price was allocated to the assets purchased and the liabilities assumed based upon the estimated fair values at the date of acquisition. The purchase accounting fair value adjustments are being amortized under various methods and over the lives of the corresponding assets and liabilities. Goodwill recorded for the acquisition amounted to $23.9 million. Intangible assets recorded for the acquisition that are subject to amortization were as follows in thousands of dollars as of December 31, 2002: Gross Accumulated Amount Amortization ------ ------------ Core deposits $3,185 $286 Trust relationships 478 106 The amount of goodwill recorded in this transaction relative to the smaller amounts of identified intangible assets reflects that the value of GBFC related primarily to the foundation it provides to further build our presence in the Grand Rapids market. The value of this foundation lies with the GBFC workforce, their customer service orientation and their relationships within the community. The amount of the core deposits intangible asset recorded was small relative to the total purchase price and reflects that the GBFC deposit portfolio was weighted towards higher interest rate account types. Both the core deposits and trust relationships intangibles are being amortized on an accelerated basis over a period of ten years. Amortization expense through December 31, 2002 was $392,000. Estimated amortization expense for the next five years is as follows in thousands of dollars: 2003 $484 2004 440 2005 406 2006 378 2007 340 2002 Annual Report 53 Notes to Consolidated Financial Statements In conjunction with the acquisition, the fair values of significant assets and liabilities assumed were as follows as of April 1, 2002, stated in thousands of dollars: Cash and cash equivalents $ 21,390 Securities 11,070 Loans 246,344 Acquisition intangibles 27,578 Deposits (246,060) Other borrowings (20,170) The consolidated statements of income reflect the operating results of GBFC since the effective date of the acquisition. The following table presents pro forma information for year ended December 31 as if the acquisition of GBFC had occurred at the beginning of both 2002 and 2001. The pro forma information includes adjustments for the amortization of intangibles arising from the transaction, the elimination of acquisition related expenses, and the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations as they would have been, had the transactions been effected on the assumed dates. Years Ended December 31 (Dollars in thousands) 2002 2001 Pro Forma ------- ------- ---------------------------------------------- Interest income $60,780 $58,778 Interest expense 24,496 28,371 Net interest income 36,284 30,407 Provision for loan losses 3,694 2,755 Net interest income after provision 32,590 27,652 Noninterest income 8,336 7,149 Noninterest expense 26,107 23,733 Income before federal income tax 14,819 11,068 Federal income tax expense 4,865 3,530 Net income $ 9,954 $ 7,538 Basic earnings per share $ 1.25 $ 1.04 Diluted earnings per share $ 1.23 $ 1.04 NOTE 3 -- Cash and Due from Banks The Company was required to have $1,290,000 and $8,352,000 of cash on hand or on deposit with the Federal Reserve Bank to meet regulatory reserve and clearing requirements at year-end 2002 and 2001. These balances do not earn interest. NOTE 4 -- Securities The amortized cost and fair values of securities at year-end were as follows (dollars in thousands): Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Values --------- ---------- ---------- ------ Available for Sale 2002 U.S.Treasury securities and obligations of U.S. Government agencies $67,747 $2,752 $ (1) $70,498 State and municipal bonds 15,050 611 (50) 15,611 $82,797 $3,363 $(51) $86,109 Held to Maturity 2002 U.S.Treasury securities and obligations of U.S. Government agencies $ 1,369 $ 12 $ -- $ 1,381 State and municipal bonds 2,692 79 (12) 2,759 $ 4,061 $ 91 $ (12) $ 4,140 Available for Sale 2001 U.S.Treasury securities and obligations of U.S. Government agencies $53,875 $1,412 $ -- $55,287 State and municipal bonds 8,234 112 (27) 8,319 $62,109 $1,524 $ (27) $63,606 Held to Maturity 2001 State and municipal bonds $ 710 $ -- $ (61) $ 649 Contractual maturities of debt securities at December 31, 2002 were as follows (dollars in thousands):
Held to Maturity Securities Available for Sale Securities --------------------------- ----------------------------- Amortized Fair Amortized Fair Cost Value Cost Value --------- ------ --------- ------- Due in one year or less $1,292 $1,304 $ 4,069 $ 4,168 Due from one to five years 76 78 60,513 63,159 Due from five to ten years 641 628 6,855 7,155 Due after ten years 2,052 2,130 11,360 11,627 $4,061 $4,140 $82,797 $86,109
54 Macatawa Bank Corporation Notes to Consolidated Financial Statements There were no sales of securities for the years ended December 31, 2002, 2001 and 2000. At December 31, 2002 and 2001, securities with a carrying value of approximately $3,052,000 and $1,000,000 were pledged as security for public deposits and for other purposes required or permitted by law. In addition, securities totaling $70,768,000 and $54,233,000 at December 31, 2002 and 2001 were used as collateral for advances from the Federal Home Loan Bank. NOTE 5 -- Loans Year-end loans were as follows (dollars in thousands): 2002 2001 -------- -------- Commercial $341,370 $269,993 Commercial mortgage 356,310 133,428 Residential mortgage 133,843 67,655 Consumer 129,515 74,617 $961,038 $545,693 Activity in the allowance for loan losses was as follows (dollars in thousands): 2002 2001 2000 ------- ------ ------ Beginning balance $ 7,699 $5,854 $3,995 Balances from GBFC acquisition 3,464 -- -- Provision for loan losses 3,321 2,285 1,931 Loans charged-off (1,271) (513) (87) Recoveries 259 73 15 Ending balance $13,472 $7,699 $5,854 Impaired loans were as follows (dollars in thousands): 2002 2001 ------ ------ Loans with no allocated allowance for loan losses $ -- $1,798 Loans with allocated allowance for loan losses 2,477 1,821 $2,477 $3,619 Amount of the allowance for loan losses allocated $ 883 $ 539 2002 2001 2000 ------ ------ ------ Average of impaired loans during the period $2,594 $1,013 $472 Interest income recognized during impairment 144 51 33 Cash-basis interest income recognized 162 62 27 NOTE 6 -- Premises and Equipment -- Net Year-end premises and equipment were as follows (dollars in thousands): 2002 2001 ------- ------- Land $ 5,410 $ 3,819 Building 9,399 6,596 Leasehold improvements 1,870 1,286 Furniture and equipment 9,857 6,668 Construction in progress 6,224 116 32,760 18,485 Less accumulated depreciation (7,009) (3,635) $25,751 $14,850 Depreciation expense was $1,872,000, $1,406,000 and $1,268,000 for each of the years ending December 31, 2002, 2001 and 2000. The Banks lease certain office and branch premises and equipment under operating lease agreements. Total rental expense for all operating leases aggregated $648,000, $311,000 and $244,000 for each of the years ending December 31, 2002, 2001 and 2000. Future minimum rentals under noncancelable operating leases as of December 31, 2002 are as follows (dollars in thousands): 2003 $491 2004 222 2005 140 2006 11 2007 -- $864 2002 Annual Report 55 Notes to Consolidated Financial Statements NOTE 7 -- Deposits Deposits at year-end were as follows (dollars in thousands): 2002 2001 -------- -------- Noninterest-bearing demand $103,030 $ 60,829 Money market 237,636 175,835 NOW and Super NOW 140,822 71,544 Savings 28,730 18,397 Certificates of deposit 410,655 199,587 $920,873 $526,192 The following table depicts the maturity distribution of certificates of deposits at December 31, 2002 (dollars in thousands): 2003 $202,564 2004 113,576 2005 66,999 2006 6,850 2007 20,438 Thereafter 228 $410,655 The Banks had approximately $257,516,000 and $100,504,000 in time certificates of deposit, which were in denominations of $100,000 or more at December 31, 2002 and 2001. Brokered deposits totaled approximately $107,083,000 and $11,504,000 at December 31, 2002 and 2001. At December 31, 2002 and 2001, brokered deposits had interest rates ranging from 2.10% to 7.25% and 3.0% to 7.30% respectively, and maturities ranging from one month to three years. NOTE 8 -- Federal Home Loan Bank Advances At year-end, advances from the Federal Home Loan Bank were as follows (dollars in thousands): 2002 2001 -------- ------- Maturities from March 2003 through December 2010, rates from 1.80% to 6.95%, averaging 5.19% at December 31, 2002 $106,897 Maturities from February 2002 through December 2010, rates from 2.76% to 6.68%, averaging 5.30% at December 31, 2001 $75,638 Each advance was payable at its maturity date and contains a prepayment penalty. The advances were collateralized by securities totaling $70,768,000 and $54,233,000 and first mortgage loans totaling $95,530,000 and $65,496,000 under a blanket lien arrangement at December 31, 2002 and 2001. Advances with put options held by the Federal Home Loan Bank amounted to $41,000,000 at December 31, 2002 and 2001. Maturities over the next five years are as follows (dollars in thousands): 2003 $ 33,454 2004 22,929 2005 17,500 2006 -- 2007 -- Thereafter 33,014 $106,897 NOTE 9 -- Other Borrowings The Company has a $10,000,000 credit facility to provide liquidity for the parent company and additional capital for the bank subsidiaries as necessary. Maturity dates and interest rates on advances of this credit facility are as follows (dollars in thousands): Maturity Date Interest Rate 2002 2001 -------------- ------------- ------ ---- April 30, 2003 2.92% $4,500 $ -- These borrowings were secured with 235,000 shares of common stock of Macatawa Bank. NOTE 10 -- Related Party Transactions Loans to principal officers, directors, and their affiliates were as follows (dollars in thousands): 2002 2001 -------- -------- Beginning balance $ 14,215 $ 14,239 Balances from Grand Bank acquisition 1,974 -- New loans and renewals 15,151 8,835 Repayments and renewals (10,681) (8,525) Effect of changes in related parties -- (334) Ending balance $ 20,659 $ 14,215 Deposits from principal officers, directors, and their affiliates at December 31, 2002 and 2001 were $5,758,000 and $5,482,000. 56 Macatawa Bank Corporation Notes to Consolidated Financial Statements NOTE 11 -- Stock Options Options to buy stock are granted to officers and employees under the Employee Stock Option Plan (the Employees' Plan), which provides for issue of up to 520,000 options. Options are also granted to directors under the Directors' Stock Option Plan (the Directors' Plan), which provides for issuance of up to 146,848 options. In conjunction with the acquisition of Grand Bank Financial Corporation during the first quarter 2002, an additional 86,040 in options were authorized to exchange existing GBFC options outstanding. The exercise price is the market price at the date of grant for both plans. The maximum option term is ten years with options vesting over a one-year period for both the Employees' Plan and the Directors' Plan. A summary of the activity in the plans is as follows: Weighted Average Options Outstanding Exercise Price ------------------- ---------------- Balance at January 1, 2000 150,282 $12.19 Granted 25,280 11.81 Exercised (803) 9.34 Forfeited -- -- Balance at December 31, 2000 174,759 12.15 Granted 26,322 16.96 Exercised (428) 9.62 Forfeited (696) 10.91 Balance at December 31, 2001 199,957 12.80 Granted 104,830 19.31 GBFC options exchanged 86,040 4.34 Exercised (15,256) 6.07 Forfeited (5,720) 19.68 Balance at December 31, 2002 369,851 $12.85 Options outstanding at year-end 2002 were as follows:
Outstanding Exercisable --------------------------------------------- -------------------------- Weighted Average Remaining Contractual Life Weighted Average Weighted Average Range of Exercise Prices Number in Years Exercise Price Number Exercise Price ------------------------ ------- ---------------- ---------------- ------- ---------------- $2.50 - $5.00 56,262 2.0 $ 3.16 56,262 $ 3.16 $5.01 - $10.00 85,265 5.6 9.09 85,265 9.09 $10.01 - $15.00 56,024 7.1 12.80 56,024 12.80 $15.01 - $21.00 172,300 8.7 17.90 73,188 15.96 Outstanding at year end 369,851 6.7 $12.85 270,739 $10.48
2002 Annual Report 57 Notes to Consolidated Financial Statements NOTE 12 -- Employee Benefits The Company sponsors a 401(k) plan which covers substantially all employees. Employees may elect to contribute to the plan from 1.0% to 15.0% of their salary subject to statutory limitations. The Company makes matching contributions equal to 100.0% of the first 3.0% of employee contributions. Effective July 1,2002 the plan was amended to establish additional Company matching contributions equal to 50.0% of employee contributions in excess of 3.0% and up to 6.0%. The Company's contribution for the years ended December 31,2002 and 2001 were approximately $294,000 and $165,000. The Company sponsors an employee stock purchase plan which allows employees to defer after-tax payroll dollars and purchase Company stock on a quarterly basis. The Company has reserved 25,000 shares of common stock to be issued and purchased under the plan, however, the plan allows for shares to be purchased directly from the Company or on the open market. Grand Bank has a defined benefit pension plan covering substantially all of its employees.This plan was curtailed in conjunction with the acquisition of Grand Bank effective April 1, 2002. Financial information regarding the plan was as follows subsequent to the acquisition through and as of December 31, 2002. Benefit obligation at year-end $(833,060) Fair value of plan assets at year-end 805,950 Funded status $ (27,110) Net benefit cost $ (8,567) Employer contributions 165,564 Benefits paid 521,581 The weighted average discount rate used in determining the actuarial present value of the benefit obligation was 7.0% and the weighted average expected return on plan assets was 8.0%. NOTE 13 -- Earnings Per Share A reconciliation of the numerators and denominators of basic and diluted earnings per share are as follows (dollars in thousands except per share data):
2002 2001 2000 ---------- ---------- ---------- Basic earnings per share Net income $ 9,513 $ 5,116 $ 3,349 Weighted average common shares outstanding 7,352,671 4,757,578 3,844,201 Basic earnings per share $ 1.29 $ 1.08 $ 0.87 Diluted earnings per share Net income $ 9,513 $ 5,116 $ 3,349 Weighted average common shares outstanding 7,352,671 4,757,578 3,844,201 Add: Dilutive effects of assumed exercises of stock options 112,589 38,414 15,292 Weighted average common and dilutive potential common shares outstanding 7,465,260 4,795,992 3,859,493 Diluted earnings per share $ 1.27 $ 1.07 $ 0.87
Stock options for 39,000, 24,180, and 81,411 shares of common stock were not considered in computing diluted earnings per share for December 31, 2002, 2001 and 2000 because they were antidilutive. 58 Macatawa Bank Corporation Notes to Consolidated Financial Statements NOTE 14 -- Federal Income Taxes The consolidated provision for income taxes was as follows (dollars in thousands): 2002 2001 2000 ------ ------ ------ Current $5,348 $3,139 $1,889 Deferred benefit (696) (642) (534) Change in valuation allowance -- -- (656) $4,652 $2,497 $ 699 The difference between the financial statement tax expense and amount computed by applying the statutory federal tax rate of 34.0% to pretax income was reconciled as follows (dollars in thousands): 2002 2001 2000 ------ ------ ------ Statutory rate applied to income before taxes $4,816 $2,588 $1,376 Add (deduct) Tax-exempt interest income (187) (90 (24) Change in valuation allowance -- -- (656) Other 23 (1) 3 $4,652 $2,497 $ 699 The net deferred tax asset recorded included the following amounts of deferred tax assets and liabilities (dollars in thousands): 2002 2001 ------- ------ Deferred tax asset Allowance for loan losses $ 4,364 $2,472 Accrued expenses 321 38 Organization costs 18 14 Other 30 21 4,733 2,545 Deferred tax liabilities Depreciation (401) (338) Purchase accounting adjustments (1,031) -- Unrealized gain on securities available for sale (1,126) (509) Unrealized gain on derivative instruments (338) -- Accretion (14) (16) Other (20) -- (2,930) (863) Net deferred tax asset $ 1,803 $1,682 A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. Based on the levels of taxable income in the current and prior years which would be available to absorb the benefit, management has determined that no valuation allowance was required at December 31, 2002 or 2001. NOTE 15 -- Commitments and Off-Balance-Sheet Risk Some financial instruments are used to meet customer financing needs and to reduce exposure to interest rate changes. These financial instruments include commitments to extend credit and standby letters of credit. These involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the financial statements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment, and generally have fixed expiration dates. Standby letters of credit are conditional commitments to guarantee a customer's performance to a third party. Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit and standby letters of credit. Collateral or other security is normally not obtained for these financial instruments prior to their use, and many of the commitments are expected to expire without being used. A summary of the notional or contractual amounts of financial instruments with off-balance-sheet risk was as follows (dollars in thousands): December 31 2002 2001 -------------------------------------------- -------- -------- Commitments to make loans $ 58,636 $ 83,272 Unused lines of credit and letters of credit 307,595 187,422 Approximately 34.0% of the Bank's commitments to make loans were at fixed rates, offered at current market rates. The majority of the variable rate commitments noted above were tied to prime and expire within 30 days. The majority of the unused lines of credit were at variable rates tied to prime. The Bank conducts substantially all of its business operations in western Michigan. NOTE 16 -- Hedging Activities The Company has asset/liability management policies that include guidelines for measuring and monitoring interest rate risk. Within these guidelines, parameters have been established for maximum fluctuations in net interest income. Possible fluctuations are measured and monitored using simulation modeling. The policies provide for the use of derivative instruments and hedging activities to aid in managing interest rate risk within the policy parameters. The Company's assets are comprised of a large portion of loans on which the interest rates are variable. As such, the Company may periodically enter into derivative financial instruments to mitigate exposure to fluctuations in cash flows resulting from changes in interest rates. Interest rate swap arrangements may be utilized to hedge against these fluctuations in cash flows. 2002 Annual Report 59 Notes to Consolidated Financial Statements In May 2002,the Company entered into a three-year interest rate swap arrangement that converted the variable rate cash inflows on certain loans to fixed rates of interest. This interest rate swap bears a notional amount of $20 million, pays interest to the Company at a fixed rate, and requires interest payments from the Company at a variable rate. It is anticipated that approximately $276,000,net of tax, of unrealized gains on this cash flow hedge at December 31,2002 will be reclassified to earnings over the next twelve months. NOTE 17 -- Regulatory Matters The Company and the Banks 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. For the Banks, if only adequately capitalized, regulatory approval is required to accept brokered deposits; and if undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required. At December 31, 2002 and 2001, actual capital levels (dollars in thousands) and minimum required levels were:
Minimum Required To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations --------------- ----------------- ----------------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------- ----- December 31, 2002 Total capital (to risk weighted assets) Consolidated $97,449 9.9% $78,860 8.0% $98,576 10.0% Macatawa Bank 71,618 10.0 57,197 8.0 71,496 10.0 Grand Bank 28,879 10.7 21,628 8.0 27,035 10.0 Tier 1 capital (to risk weighted assets) Consolidated 85,127 8.6 39,430 4.0 59,145 6.0 Macatawa Bank 62,681 8.8 28,599 4.0 42,898 6.0 Grand Bank 21,000 7.8 10,814 4.0 16,221 6.0 Tier 1 capital (to average assets) Consolidated 85,127 7.6 44,657 4.0 55,821 5.0 Macatawa Bank 62,681 7.7 32,628 4.0 40,785 5.0 Grand Bank 21,000 7.1 11,879 4.0 14,849 5.0 December 31, 2001 Total capital (to risk weighted assets) Consolidated $72,573 12.9% $45,175 8.0% $56,468 10.0% Macatawa Bank 58,264 10.3 45,159 8.0 56,449 10.0 Tier 1 capital (to risk weighted assets) Consolidated 65,514 11.6 22,587 4.0 33,881 6.0 Macatawa Bank 51,208 9.1 22,579 4.0 33,869 6.0 Tier 1 capital (to average assets) Consolidated 65,514 10.1 25,838 4.0 32,297 5.0 Macatawa Bank 51,208 7.9 25,830 4.0 32,287 5.0
The Banks were categorized as well capitalized at December 31, 2002 and 2001. Banking regulations limit capital distributions. Generally, capital distributions are limited to undistributed net income for the current and prior two years. At December 31, 2002 and 2001, approximately $10,947,000 and $1,815,000 was available to pay dividends to the holding company. 60 Macatawa Bank Corporation Notes to Consolidated Financial Statements NOTE 18 -- Fair Values of Financial Instruments Carrying amount and estimated fair values of financial instruments were as follows at year-end (dollars in thousands):
2002 2001 --------------------- --------------------- Carrying Fair Carrying Fair Amount Value Amount Value --------- --------- --------- --------- Financial assets Cash and cash equivalents $ 47,874 $ 47,874 $ 34,198 $ 34,198 Securities available for sale 86,109 86,109 63,606 63,606 Securities held to maturity 4,061 4,140 710 649 Federal Home Loan Bank stock 5,391 5,391 3,782 3,782 Loans held for sale 18,726 18,781 4,571 4,571 Loans, net 947,566 958,531 537,994 542,169 Accrued interest receivable 4,411 4,411 3,247 3,247 Financial liabilities Deposits (920,873) (928,180) (526,192) (528,249) Other borrowings (4,936) (4,936) -- -- Federal funds purchased (20,000) (20,000) -- -- Federal Home Loan Bank advances (106,897) (119,110) (75,638) (82,432) Accrued interest payable (2,858) (2,858) (1,266) (1,266) Interest rate swaps 993 993 -- --
The methods and assumptions used to estimate fair value are described as follows: Carrying amount is the estimated fair value for cash and cash equivalents, short-term borrowings, Federal Home Loan Bank stock, accrued interest receivable and payable, demand deposits, short-term debt, 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 values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of loans held for sale is based on market quotes. Fair value of debt is based on current rates for similar financing. The fair value of interest rate swaps is based on market prices or dealer quotes. 2002 Annual Report 61 Notes to Consolidated Financial Statements NOTE 19 -- Condensed Financial Statements (Parent Company Only) Following are condensed parent company only financial statements (dollars in thousands): Condensed Balance Sheets 2002 2001 -------- ------- Assets Cash and cash equivalents $ 910 $14,011 Investment in subsidiaries 112,996 52,296 Total loans 4,500 -- Other assets 105 196 Total assets $118,511 $66,503 Liabilities and Shareholders' Equity Other borrowings $ 4,500 $ -- Other liabilities 37 1 Total liabilities 4,537 1 Shareholders' equity Common stock 105,201 62,334 Retained earnings 5,931 3,180 Accumulated other comprehensive income 2,842 988 Total shareholders' equity 113,974 66,502 Total liabilities and shareholders' equity $118,511 $66,503 Condensed Statements of Income 2002 2001 2000 ------ ------ ------ Income Interest income $ 121 $ -- $ -- Dividends from subsidiaries 1,000 625 -- Total income 1,121 625 -- Expense Interest expense 120 -- -- Other expense 435 387 231 Total expense 555 387 231 Income (loss) before income tax and equity in undistributed net income of subsidiaries 566 238 (231) Equity in undistributed net income of subsidiaries 8,799 4,746 3,434 Income before income tax 9,365 4,984 3,203 Federal income tax expense (benefit) (148) (132) (146) Net income $9,513 $5,116 $3,349 62 Macatawa Bank Corporation Notes to Consolidated Financial Statements
Condensed Statements of Cash Flows (Dollars in thousands) 2002 2001 2000 ----------------------------------------------------------- -------- ------- ------- Cash flows from operating activities Net income $ 9,513 $ 5,116 $ 3,349 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in undistributed earnings of subsidiaries (8,799) (4,746) (3,434) (Increase) decrease in other assets 91 (51) (146) Increase (decrease) in other liabilities 36 (2) 3 Net cash from operating activities 841 317 (228) Cash flows from investing activities Origination of loan to subsidiary (4,500) -- -- Investment in subsidiaries (9,243) (5,100) (8,000) Net cash from investing activities (13,743) (5,100) (8,000) Cash flows from financing activities Other borrowings 4,500 (4,000) 4,000 Proceeds from issuance of common stock 93 23,681 7 Fractional shares purchased (7) (3) -- Shares repurchased (2,300) Cash dividends paid (2,485) (1,307) (251) Net cash from financing activities (199) 18,371 3,756 Net change in cash and cash equivalents (13,101) 13,588 (4,472) Cash and cash equivalents at beginning of year 14,011 423 4,895 Cash and cash equivalents at end of year $ 910 $14,011 $ 423
NOTE 20 -- Quarterly Financial Data (Unaudited)
Earnings Per Share ------------------ Interest Net Interest Net Fully (Dollars in thousands except per share data) Income Income Income Basic Diluted -------------------------------------------- -------- ------------ ------ ----- ------- 2002 First quarter $10,522 $6,157 $1,514 $0.28 $0.27 Second quarter 15,000 8,814 2,350 0.29 0.29 Third quarter 15,810 9,474 2,735 0.34 0.34 Fourth quarter 15,918 9,902 2,915 0.37 0.36 2001 First quarter $10,280 $4,831 $1,091 $0.29 $0.28 Second quarter 10,639 5,195 1,202 0.29 0.29 Third quarter 11,108 5,675 1,351 0.25 0.24 Fourth quarter 10,658 6,057 1,472 0.27 0.26
2002 Annual Report 63 Board of Directors and Management Team Board of Directors of Macatawa Bank Benj.A. Smith III* Chairman/CEO - Macatawa Bank Corporation President - Smith & Associates Philip J. Koning* President/CEO - Macatawa Bank James L. Batts Vice Chairman - Belfry Development Corporation G.Thomas Boylan* President - Light Metals Corporation Jessie F. Dalman Former Representative Michigan - House of Representatives Robert Den Herder* President - Premovation Audio Wayne J. Elhart President - Elhart Pontiac GMC Jeep; Vice President - Elhart Dodge Nissan James L. Jurries President - Jurries Capital Management, Inc. John F. Koetje* Partner - John F.Koetje and Associates * Also serve as director of Macatawa Bank Corporation Board of Directors of Grand Bank Thomas Wesholski Chairman/CEO - Grand Bank Henry Bouma Chairman - Lumbermen's, Inc. Lawrence Leigh President - Leigh's of Western Michigan, Inc. Gary Vos Chairman - Dan Vos Construction Bill Hardiman Mayor - City of Kentwood Douglas F.Meijer Co-Chairman - Meijer, Inc. J.C.Huizenga Chairman - Westwater Group Owen Pyle Jr. President - Concord Enterprises, Inc. Birgit M. Klohs President - The Right Place Program Dana E. Sommers President - The Grotenhuis Group Harvey J. Koning President - Grand Oldsmobile Gordon L. Stauffer President - Northland Corporation Bank Management Team Philip J. Koning President/CEO - Macatawa Bank Thomas Wesholski Chairman/CEO - Grand Bank Kenneth J. Hoexum President/COO - Grand Bank Jon Swets Senior Vice President/Chief Financial Officer - Macatawa Bank Ray D. Tooker Senior Vice President Loan Administration - Macatawa Bank Jill A. Walcott Senior Vice President Branch Administration - Macatawa Bank Richard D. Wieringa Senior Vice President Commercial Loans - Macatawa Bank Brian Downs Senior Vice President Trust - Grand Bank Vicki K. DenBoer Vice President Consumer Loans - Macatawa Bank Linda Elenbaas Vice President Operations and Technology - Macatawa Bank Steven L. Germond Vice President/Financial Officer - Grand Bank Colette S. Neumann Vice President Controller - Macatawa Bank Judith A. Swanson Vice President Human Resources - Macatawa Bank Sandy Tanis Vice President Trust Operations - Macatawa Bank Macatawa Bank Branch Locations Allendale 6299 Lake Michigan Drive - 616.895.9892 Byron Center 8233 Byron Center Avenue, Suite Q - 616.583.2244 Douglas 132 South Washington - 269.857.8398 Grand Rapids 4590 Cascade Road, SE - 616.942.3710 Grandville 4471 Wilson Avenue, SW - 616.531.2209 Hamilton 4758 136th Avenue - 269.751.2505 Holland 139 East 8th Street - 616.820.1320 701 Maple Avenue - 616.820.1330 489 Butternut Drive - 616.786.9555 699 East 16th Street - 616.393.8527 20 E.Lakewood Boulevard - 616.594.2100 Hudsonville 3526 Chicago Drive - 616.379.1375 Jenison 2020 Baldwin Street - 616.662.5419 Wyoming 5271 Clyde Park Avenue, SW - 616.531.0051 Zeeland 51 East Main - 616.748.9491 41 North State Street - 616.748.9847 Grand Bank Location Grand Rapids 126 Ottawa Avenue, NW - 616.235.7000 Administrative Offices 160 South Waverly Road, Holland - 616.820.1444 Trust Department 106 East 8th Street, Holland - 616.820.1350 126 Ottawa Avenue, NW, Grand Rapids - 616.235.7000 Commercial Lending Center 348 South Waverly Road, 2-D, Holland - 616.820.1438 Retail Lending Center 348 South Waverly Road, 2-A, Holland - 616.393.0583 64 Macatawa Bank Corporation Corporate Data Quarterly Stock Price Information The Company's common stock has been quoted on the Nasdaq National Market since May 17, 2001. Previous to that, the stock was traded on the Nasdaq SmallCap Market. High and low sales prices (as reported on the Nasdaq National Market) for each quarter for the years ended December 31, 2002 and 2001, are set forth in the table below. This information has been restated for the 3% stock dividend paid in May 2001 and the 4% stock dividend paid in May 2002. 2002 2001 --------------- --------------- High Low High Low ------ ------ ------ ------ Quarter First Quarter $20.87 $18.13 $14.00 $12.60 Second Quarter $21.74 $18.46 $17.31 $13.53 Third Quarter $21.50 $17.00 $17.55 $15.32 Fourth Quarter $20.85 $17.14 $18.51 $15.14 On February 26, 2003 there were approximately 749 owners of record and, in addition, approximately 0000 beneficial owners of the Company's common stock. The Company declared its first cash dividend, amounting to $.07 per share, during the fourth quarter of 2000. Quarterly cash dividends totaling $.28 were paid during 2001, and a 3% stock dividend was declared during the second quarter of 2001. Quarterly cash dividends totaling $.34 were paid during 2002, and a 4% stock dividend was declared during the second quarter of 2002. Shareholder Information Administrative Offices 10717 Paw Paw Drive, Holland, MI 49424 - 616.820.1444 Annual Meeting Ridgepoint Community Church, 340 - 104th Avenue Holland, MI 49423 Date: April 24, 2003 Time: 10:00 a.m. Investor Relations and Form 10-K Questions regarding corporate earnings releases, financial information, and other investor data should be addressed to: Macatawa Bank 10717 Paw Paw Drive Holland, MI 49424 616.820.1435 Forms 10-K, 10-Q and others can be accessed through our website at www.macatawabank.com. Transfer Agent Registrar and Transfer Company 10 Commerce Drive, Cranford, New Jersey 07016-3572 1.800.368.5948 E-mail Info@RTCo.com Internet www.RTCO.com General Counsel Varnum, Riddering, Schmidt & Howlett LLP Independent Auditor Crowe, Chizek and Company LLP Online Information For the most current news releases and Macatawa Bank Corporation financial reports and product information, visit our website at www.macatawabank.com.