10-Q 1 form10-q_1stqtr2005.txt Q1 2005 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [ X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from ________ to ________ Commission File Number: 000-26099 FARMERS & MERCHANTS BANCORP (Exact name of registrant as specified in its charter) Delaware 94-3327828 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 111 W. Pine Street, Lodi, California 95240 (Address of principal Executive offices) (Zip Code) Registrant's telephone number, including area code (209) 367-2300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ X ] No [ ] Number of shares of common stock of the registrant: Par value $0.01, authorized 2,000,000 shares; issued and outstanding 792,709 as of April 29, 2004. 1 FARMERS & MERCHANTS BANCORP FORM 10-Q TABLE OF CONTENTS PART I. - FINANCIAL INFORMATION Page Item 1 - Financial Statements Consolidated Balance Sheets as of March 31, 2005, December 31, 2004 and March 31, 2004. 4 Consolidated Statements of Income for the Three Months Ended March 31, 2005 and 2004. 5 Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2005 and 2004. 6 Consolidated Statement of Changes in Shareholders' Equity for the Three Months Ended March 31, 2005 and 2004. 7 Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2005 and 2004. 8 Notes to Unaudited Consolidated Financial Statements 9 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 25 Item 4 - Controls and Procedures 29 PART II. - OTHER INFORMATION 29 ----------------- Item 1 - Legal Proceedings 29 Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 29 Item 3 - Defaults Upon Senior Securities 30 Item 4 - Submission of Matters to a Vote of Security Holders 30 Item 5 - Other Information 30 2 Item 6 - Exhibits 30 Signatures 31 Index to Exhibits 32 3 PART I. - FINANCIAL INFORMATION Item 1 - Financial Statements
FARMERS & MERCHANTS BANCORP Consolidated Balance Sheets -------------------------------------------------------------- ------------- -------------- --------------- (in thousands) March 31, December 31, March 31, 2005 2004 2004 Assets (Unaudited) (Unaudited) -------------------------------------------------------------- ------------- -------------- --------------- Cash and Cash Equivalents: Cash and Due From $32,566 $32,170 $34,764 Federal Funds Sold 2,700 0 2,900 -------------------------------------------------------------- ------------- -------------- --------------- Total Cash and Cash Equivalents 35,266 32,170 37,664 Investment Securities: Available-for Sale 162,763 185,488 210,330 Held-to-Maturity 113,145 89,952 35,981 -------------------------------------------------------------- ------------- -------------- --------------- Total Investment Securities 275,908 275,440 246,311 -------------------------------------------------------------- ------------- -------------- --------------- Loans 859,066 869,082 799,034 Less: Unearned Income (2,234) (2,174) (1,929) Less: Allowance for Loan Losses (17,758) (17,727) (17,564) -------------------------------------------------------------- ------------- -------------- --------------- Loans, Net 839,074 849,181 779,541 -------------------------------------------------------------- ------------- -------------- --------------- Land, Buildings & Equipment 14,913 14,971 11,130 Bank Owned Life Insurance 35,606 35,235 34,073 Interest Receivable and Other Assets 20,811 19,298 12,842 -------------------------------------------------------------- ------------- -------------- --------------- Total Assets $1,221,578 $1,226,295 $1,121,561 ============================================================== ============= ============== =============== Liabilities & Shareholders' Equity -------------------------------------------------------------- ------------- -------------- --------------- Deposits: Demand $247,812 $273,799 $217,328 Interest Bearing Transaction 114,049 108,213 93,655 Savings 313,099 301,225 279,263 Time Deposits 355,049 318,873 316,346 -------------------------------------------------------------- ------------- -------------- --------------- Total Deposits 1,030,009 1,002,110 906,592 -------------------------------------------------------------- ------------- -------------- --------------- FHLB Borrowings 40,878 80,889 80,918 Subordinated Debentures 10,310 10,310 10,310 Other Liabilities 20,936 16,439 10,278 -------------------------------------------------------------- ------------- -------------- --------------- Total Liabilities 1,102,133 1,109,748 1,008,098 -------------------------------------------------------------- ------------- -------------- --------------- Shareholders' Equity Common Stock 8 8 8 Additional Paid In Capital 82,231 82,237 71,560 Retained Earnings 39,763 35,332 41,551 Accumulated Other Comprehensive (Loss) Income (2,557) (1,030) 344 -------------------------------------------------------------- ------------- -------------- --------------- Total Shareholders' Equity 119,445 116,547 113,463 -------------------------------------------------------------- ------------- -------------- --------------- Total Liabilities & Shareholders' Equity $1,221,578 $1,226,295 $1,121,561 ============================================================== ============= ============== ===============
The accompanying notes are an integral part of these unaudited consolidated financial statements 4 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Income (Unaudited) --------------------------------------------------------------------------------- ------------ (in thousands) Three Months Ended March 31, 2005 2004 --------------------------------------------------------------------- ----------- ------------ Interest Income Interest & Fees on Loans $13,436 $11,673 Federal Funds Sold 42 52 Securities: Taxable 1,895 1,726 Non-taxable 720 594 --------------------------------------------------------------------- ----------- ------------ Total Interest Income 16,093 14,045 --------------------------------------------------------------------- ----------- ------------ Interest Expense Interest Bearing Transaction 19 14 Savings 326 256 Time Deposits 1,655 1,322 Interest on Borrowed Funds 589 716 Interest on Subordinated Debentures 140 105 --------------------------------------------------------------------- ----------- ------------ Total Interest Expense 2,729 2,413 --------------------------------------------------------------------- ----------- ------------ Net Interest Income 13,364 11,632 Provision for Loan Losses - 375 --------------------------------------------------------------------- ----------- ------------ Net Interest Income After Provision for Loan Losses 13,364 11,257 --------------------------------------------------------------------- ----------- ------------ Non-Interest Income Service Charges on Deposit Accounts 1,034 1,189 Net Gain on Sale of Investment Securities 161 641 Credit Card Merchant Fees 460 384 Increase in Cash Surrender Value of Life Insurance 371 420 Other 876 910 --------------------------------------------------------------------- ----------- ------------ Total Non-Interest Income 2,902 3,544 --------------------------------------------------------------------- ----------- ------------ Non-Interest Expense Salaries & Employee Benefits 6,305 6,053 Occupancy 530 459 Equipment 475 440 Credit Card Collection Assessment 319 251 Other Operating 1,670 1,495 --------------------------------------------------------------------- ----------- ------------ Total Non-Interest Expense 9,299 8,698 --------------------------------------------------------------------- ----------- ------------ Net Income Before Taxes 6,967 6,103 Provision for Income Taxes 2,536 2,201 --------------------------------------------------------------------- ----------- ------------ Net Income $4,431 $3,902 ===================================================================== =========== ============ Earnings Per Share $ 5.59 $ 4.88 ===================================================================== =========== ============
The accompanying notes are an integral part of these unaudited consolidated financial statements 5 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Comprehensive Income (Unaudited) --------------------------------------------------------------------------------------- ---------- ----------- (in thousands) For Three Months Ended March 31, 2005 2004 --------------------------------------------------------------------------------------- ---------- ----------- Net Income $4,431 $3,902 Other Comprehensive (Loss)Income - Unrealized Gains on Derivative Instruments: Unrealized holding gains arising during the period, net of income tax effects of $0 and $75 for the quarters ended March 31, 2005 and 2004, respectively. - 104 Less: Reclassification adjustment for realized gains included in net income, net of related income tax effects of $(3) and $(32) for the quarters ended March 31, 2005 and 2004, respectively. (4) (44) Unrealized Gains (Losses) on Securities: Unrealized holding gains (losses) arising during the period, net of income tax effects of $(1,098) and $882 for the quarters ended March 31, 2005 and 2004, respectively. (1,513) 1,215 Less: Reclassification adjustment for realized gains included in net income, net of related income tax effects of $(7) and $(269) for the quarters ended March 31, 2005 and 2004, respectively. (10) (372) --------------------------------------------------------------------------------------- ---------- ----------- Total Other Comprehensive (Loss)Income (1,527) 903 --------------------------------------------------------------------------------------- ---------- ----------- Comprehensive Income $2,904 $4,805 ======================================================================================= ========== ===========
The accompanying notes are an integral part of these unaudited consolidated financial statements 6 FARMERS & MERCHANTS BANCORP
Consolidated Statements of Changes in Shareholders' Equity (Unaudited) ----------------------------------------------------------------------------------- ---------------- -------------- (in thousands except share data) Accumulated Common Additional Other Total Shares Common Paid-In Retained Comprehensive Shareholders' Outstanding Stock Capital Earnings Income Equity ------------------------------------- ------------ ---------- ----------- --------- ---------------- -------------- Balance, December 31, 2003 763,274 $ 8 $ 72,506 $37,650 $ (559) $ 109,605 ===================================== ============ ========== =========== ========= ================ ============== Net Income - - 3,902 - 3,902 Redemption of Stock (2,632) - (946) (1) - (947) Unrealized Gains on Derivitive Instruments 60 60 Changes in Net Unrealized Gain (Loss)on Securities Available for Sale - - - 843 843 ------------------------------------- ------------ ---------- ----------- --------- ---------------- -------------- Balance, March 31, 2004 760,642 $ 8 $ 71,560 $41,551 $ 344 $ 113,463 ===================================== ============ ========== =========== ========= ================ ============== Balance, December 31, 2004 792,722 $ 8 $ 82,237 $35,332 $ (1,030) $ 116,547 ===================================== ============ ========== =========== ========= ================ ============== Net Income - - 4,431 - 4,431 Redemption of Stock (13) - (6) - - (6) Unrealized Gains on Derivitive Instruments (4) (4) Changes in Net Unrealized Gain (Loss)on Securities Available for Sale - - - (1,523) (1,523) ------------------------------------- ------------ ---------- ----------- --------- ---------------- -------------- Balance, March 31, 2005 792,709 $ 8 $ 82,231 $39,763 $ (2,557) $ 119,445 ===================================== ============ ========== =========== ========= ================ ==============
The accompanying notes are an integral part of these unaudited consolidated financial statements 7 FARMERS & MERCHANTS BANCORP
Consolidated Statement of Cash Flows (Unaudited) Three Months Ended ------------------------------------------------------------------------------------- ---------------------------- (in thousands) Mar. 31 Mar. 31 2005 2004 ----- ------------------------------------------------------------------------------- ------------- -------------- Operating Activities: Net Income $4,431 $3,902 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Loan Losses - 375 Depreciation and Amortization 365 389 Provision for Deferred Income Taxes - (180) Net Amortization of Investment Security Premium & Discounts 158 344 Net Gain on Sale of Investment Securities (161) (641) Net Decrease in Interest Receivable and Other Assets (9,410) 3,213 Net (Decrease) Increase in Interest Payable and Other Liabilities 4,497 (1,095) ------------------------------------------------------------------------------------- ------------- -------------- Net Cash (Used) Provided by Operating Activities (120) 6,307 Investing Activities: Securities Available-for-Sale: Purchased (10,398) (36,981) Sold, Matured or Called 30,796 51,700 Securities Held-to-Maturity: Purchased (18,258) - Matured or Called 3,394 2,092 Net Increase in Loans 10,031 9,740 Principal Collected on Loans Previously Charged Off 76 30 Net Additions to Premises and Equipment (307) (310) ------------------------------------------------------------------------------------- ------------- -------------- Net Cash Provided by Investing Activities 15,334 26,271 Financing Activities: Net Decrease in Demand, Interest-Bearing Transaction, and Savings Accounts (8,277) (5,639) Increase in Time Deposits 36,176 7,882 Net Decrease in Federal Funds Purchased - (1,000) Net Increase (Decrease) in Federal Home Loan Bank Advances Advances (40,000) (31,000) Paydowns (11) (10) Stock Redemption (6) (947) ------------------------------------------------------------------------------------- ------------- -------------- Net Cash Used by Financing Activities (12,118) (30,714) Increase (Decrease) in Cash and Cash Equivalents 3,096 1,864 Cash and Cash Equivalents at Beginning of Year 32,170 35,800 ------------------------------------------------------------------------------------- ------------- -------------- Cash and Cash Equivalents as of March 31, 2005 and March 31, 2004 $35,266 $37,664 ===================================================================================== ============= ==============
The accompanying notes are an integral part of these unaudited consolidated financial statements 8 FARMERS & MERCHANTS BANCORP NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (unaudited) For the three months ended March 31, 2005 and March 31, 2004 1. Significant Accounting Policies Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary operations are related to traditional banking activities through its subsidiary Farmers & Merchants Bank of Central California (the Bank) which was established in 1916. The Bank's wholly owned subsidiaries include Farmers & Merchants Investment Corporation and Farmers/Merchants Corp. F & M Bancorp, Inc. was created in March 2002 to protect the name F & M Bank. Farmers & Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts as trustee on deeds of trust originated by the Bank. In December 2003, the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB Statutory Trust I is a non-consolidated subsidiary per generally accepted accounting principles (GAAP), and was formed for the sole purpose of issuing Trust Preferred Securities. The following is a summary of the significant accounting and reporting policies used in preparing the consolidated financial statements. Basis of Presentation The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of the results for the interim periods presented have been included. These interim consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company's 2004 Annual Report to Shareholders on Form 10-K. The accompanying consolidated financial statements include the accounts of the Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants Investment Corporation and Farmers/Merchants Corp. Significant intercompany transactions have been eliminated in consolidation. The results of operations for the three-month period ended March 31, 2005 may not necessarily be indicative of the operating results for the full year 2005. Management has determined that since all of the commercial banking products and services offered by the Company are available in each branch of the bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank branches and report them as a single operating segment. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. 9 Certain amounts in the prior years' financial statements and related footnote disclosures have been reclassified to conform to the current-year presentation. These reclassifications have no effect on previously reported income. Cash and Cash Equivalents For purposes of the Consolidated Statements of Cash Flows, the Company has defined cash and cash equivalents as those amounts included in the balance sheet captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased Under Agreements to Resell. Generally, these transactions are for one-day periods. For these instruments, the carrying amount is a reasonable estimate of fair value. Investment Securities Investment securities are classified at the time of purchase as held-to-maturity if it is management's intent and the Company has the ability to hold the securities until maturity. These securities are carried at cost, adjusted for amortization of premium and accretion of discount using a level yield of interest over the estimated remaining period until maturity. Losses, reflecting a decline in value judged by the Company to be other than temporary, are recognized in the period in which they become probable. Securities are classified as available-for-sale if it is management's intent, at the time of purchase, to hold the securities for an indefinite period of time and/or to use the securities as part of the Company's asset/liability management strategy. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders' equity, net of related income taxes. Fair values are based on quoted market prices or broker/dealer price quotations on a specific identification basis. Gains or losses on the sale of these securities are computed using the specific identification method. Unrealized losses on these securities, reflecting a decline in value judged by the Company to be other than temporary, are recognized in the period in which they become known. Trading securities, if any, are acquired for short-term appreciation and are recorded in a trading portfolio and are carried at fair value, with unrealized gains and losses recorded in non-interest income. Loans Loans are reported at the principal amount outstanding net of unearned discounts and deferred loan fees. Interest income on loans is accrued daily on the outstanding balances using the simple interest method. Loan origination fees are deferred and recognized over the contractual life of the loan as an adjustment to the yield. Loans are placed on a non-accrual status when the collection of principal or interest is in doubt or when they become past due for 90 days or more unless they are both well-secured and in the process of collection. For this purpose a loan is considered well-secured if it is collateralized by property having a net realizable value in excess of the amount of the loan or is guaranteed by a financially capable party. When a loan is placed on non-accrual status, the accrued and unpaid interest receivable is reversed and charged against current income, thereafter; interest income is recognized only as it is collected in cash. Loans placed on a non-accrual status are returned to accrual status when the loans are paid current as to principal and interest and future payments are expected to be made in accordance with the contractual terms of the loan. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. When a loan is impaired, the recorded amount of the loan in the Consolidated Balance Sheets is based on the present value of expected future cash flows discounted at the loan's effective interest rate, or the observable or estimated market price of the loan or on the fair value of the collateral if the loan is collateral dependent. Impaired loans are placed on a non-accrual status with income reported accordingly. Cash payments are first applied as a reduction of the principal balance until collection of the remaining principal and interest can be reasonably assured. Thereafter, interest income is recognized as it is collected in cash. 10 Allowance for Loan Losses As a financial institution which assumes lending and credit risks as a principal element in its business, the Company anticipates that credit losses will be experienced in the normal course of business. Accordingly, the allowance for loan losses is maintained at a level considered adequate by management to provide for losses that are inherent in the portfolio. The allowance is increased by provisions charged to operating expense and by recoveries on loans previously charged-off and reduced by charge-offs. Management employs a systematic methodology for determining the allowance for loan losses. On a quarterly basis, management reviews the credit quality of the loan portfolio and considers many factors in determining the adequacy of the allowance at the balance sheet date. The factors evaluated in connection with the allowance may include existing general economic and business conditions affecting the key lending areas of the Company, current levels of problem loans and delinquencies, credit quality trends, collateral values, loan volumes and concentration, seasoning of the loan portfolio, specific industry conditions, recent loss experience, duration of the current business cycle, bank regulatory examination results and findings of the Company's internal credit examiners. The allowance also incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans, which are discussed more fully in Note 4 to the Consolidated Financial Statements in the Company's Annual Report to Shareholders. While the Company utilizes a systematic methodology in determining its allowance, the allowance is based on estimates, and ultimate losses may vary from current estimates. The estimates are reviewed periodically and, as adjustments become necessary, are reported in earnings in the periods in which they become probable. Derivative Instruments and Hedging Activities The Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative Instruments and Certain Hedging Activities" as amended by the Statement of Financial Accounting Standards, No. 138, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. Changes in the fair value of those derivatives are accounted for depending on the intended use of the derivative and the resulting designation under specified criteria. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, designed to minimize interest rate risk, the effective portions of the change in the fair value of the derivative are recorded in other comprehensive income net of related income taxes. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. The Company utilizes derivative financial instruments such as interest rate caps, floors, swaps and collars. These instruments are purchased and/or sold to reduce the Company's exposure to changing interest rates. The Company marks to market the value of its derivative financial instruments and reflects gain or loss in earnings in the period of change or in other comprehensive income. 11 2. Recent Accounting Developments In June 2004, the Emerging Issues Task Force of the FASB issued final guidance on its Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." A consensus was reached regarding disclosures about unrealized losses on available-for-sale debt and equity securities accounted for under FASB Statements No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This EITF describes a model involving three steps: (1) determine whether an investment is impaired; (2) determine whether the impairment is other-than-temporary; and (3) recognize the impairment loss in earnings. The EITF also requires several additional disclosures for cost-method investments. The EITF's impairment accounting guidance was effective for reporting periods beginning after June 15, 2004. For all other investments within the scope of this Issue, the disclosures are effective in annual financial statements for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments are effective for fiscal years ending after June 15, 2004. The adoption of this EITF did not have a material impact on the Company's consolidated financial statements. At March 31, 2005, management believed the impairments described above are temporary and, accordingly, no impairment loss has been recognized in the Company's consolidated statement of income. Additionally, the Financial Accounting Standards Board (FASB) staff has indicated that the FASB will likely delay until 2005 the finalization of FASB Staff Position No. EITF Issue 03-1-a, "Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of Other-than-temporary Impairment and Its Application to Certain Investments'" (EITF 03-1). It is expected that the FASB will be taking a "fresh look" at accounting for marketable securities and the meaning of other-than-temporary impairment, and thus will reconsider EITF 03-1 in its entirety. Accordingly, FSP No. EITF 03-1-a was not issued before the end of 2004. On March 16, 2005 the FASB agreed to discuss a joint impairment convergence project with the International Accounting Standards Board (IASB). This discussion will take place on April 21, 2005. Other than this agreement to discuss the project, there have been no new developments toward resolving EITF 03-1 and we continue to rely on pre-03-1 guidance when dealing with other than temporary impairment. 3. Interim-Period Disclosure of Employee Benefit Plans Components of Net Periodic Pension Cost: Three months ended March 31 Pension Benefits ----------------------------------- (in thousands) 2005 2004 -------------- ------------- Service cost $ 13 $ 12 Interest cost 65 64 Expected return on assets (29) (57) Amortization of (gain)/loss 237 126 Amortization of prior service cost 0 0 Amortization of transition obligation 0 0 -------------- ------------- Net periodic pension cost $286 $145 ============== ============= 12 See Note 12 to the Consolidated Financial Statements in the Company's 2004 Annual Report to Shareholders for a discussion regarding the Company's intent to terminate the Defined Benefit Pension Plan during 2005. Employer Contributions The Company previously disclosed in its financial statements for the year ended December 31, 2004 that it expected to contribute $1.6 million to its Pension Plan in 2005. As of March 31, 2005, $0 has been contributed to the Plan. The Company still expects to contribute at least $1.6 million to the Plan in 2005. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This quarterly report contains various forward-looking statements, usually containing the words "estimate," "project," "expect," "objective," "goal," or similar expressions and includes assumptions concerning the Company's operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to risk and uncertainties. In connection with the "safe-harbor" provisions of the private Securities Litigation Reform Act, the Company provides the following cautionary statement identifying important factors which could cause the actual results of events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Such factors include the following: (i) the effect of changing regional and national economic conditions; (ii) significant changes in interest rates and prepayment speeds; (iii) credit risks of commercial, agricultural, real estate, consumer, and other lending activities; (iv) changes in federal and state banking laws or regulations; (v) competitive pressure in the banking industry; (vi) changes in governmental fiscal or monetary policies; (vii) uncertainty regarding the economic outlook resulting from the continuing war on terrorism, as well as actions taken or to be taken by the U.S. or other governments as a result of further acts or threats of terrorism; (viii) dividend restrictions; (ix) asset/liability pricing risks and liquidity risks; (x) changes in the securities markets; (xi) certain operational risks involving data processing systems or fraud; (xii) the State of California's fiscal difficulties; and (xiii) other external developments which could materially impact the Company's operational and financial performance. Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made. Introduction Farmers & Merchants Bancorp is a bank holding company formed March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California was formed in 1916. The Bank services the northern Central Valley of California with 18 banking offices. The service area includes Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock and Hilmar. Substantially all of the Company's business activities are conducted within its market area. As a bank holding company, the Company is subject to regulation and examination by the Board of Governors of the Federal Reserve System ("FRB"). The Bank is a California state-chartered bank subject to the regulation and examination of the California Department of Financial Institutions. Since August 1, 1940, the Bank has also been a member of the Federal Reserve System and the FRB has served as 13 its primary Federal regulator. However, at a meeting of the Board of Directors of the Bank on April 5, 2005, the Board decided to withdraw from membership in the Federal Reserve System. The Bank received the FRB's approval for this action on April 18, 2005. As a result, the Bank's primary federal regulator will now be the Federal Deposit Insurance Corporation. The FRB will continue to regulate and examine the Company but not the Bank. Management and the Board believe that this change will not have any operating or financial impact on the Company or the Bank. This section should be read in conjunction with the consolidated financial statements and the notes thereto, along with other financial information included in this report. Overview The Company's primary service area encompasses the northern Central Valley of California, a region that is impacted by the seasonal needs of the agricultural industry. Accordingly, discussion of the Company's Financial Condition and Results of Operations is influenced by the seasonal banking needs of its agricultural customers (e.g., during the spring and summer customers draw down their deposit balances and increase loan borrowing to fund the purchase of equipment and planting of crops. Correspondingly, deposit balances are replenished and loans repaid in fall and winter as crops are harvested and sold). For the three months ended March 31, 2005, Farmers & Merchants Bancorp reported net income of $4,431,000, earnings per share of $5.59 and return on average assets of 1.46%. Return on average shareholders' equity was 15.04% for the three months ended March 31, 2005. For the three months ended March 31, 2004, net income totaled $3,902,000, earnings per share was $4.88 and return on average assets was 1.38%. Return on average shareholders' equity for the three months ended March 31, 2004 was 14.07%. The Company's improved earnings performance in the first quarter of 2005 when compared to the same period last year was due primarily to a combination of (1) growth in earning assets; (2) an improvement in the net interest margin due to rising interest rates; and (3) a reduction in the provision for loan losses. The following is a summary of the financial results for the three-month period ended March 31, 2005 compared to March 31, 2004. o Net income increased 13.6% to $4.4 million from $3.9 million. o Earnings per share increased 14.6% to $5.59 from $4.88. o Net interest income increased 14.9% to $13.4 million from $11.6 million. o Total assets increased 8.9% to $1.2 billion. o Gross loans increased 7.5% to $859.1 million. o Total deposits increased 13.6% to $1.0 billion. o Total shareholders' equity increased 5.3% to $119.4 million. 14 Results of Operations Net Interest Income The tables on the following pages reflect the Company's average balance sheets and volume and rate analysis for the three month periods ending March 31, 2005 and 2004. The average yields on earning assets and average rates paid on interest-bearing liabilities have been computed on an annualized basis for purposes of comparability with full year data. Average balance amounts for assets and liabilities are the computed average of daily balances. The volume and rate analysis of net interest revenue summarizes the changes in average asset and liability balances and interest earned and paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates and the total net change in interest income and expenses. The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. Net interest income is the amount by which the interest and fees on loans and other interest earning assets exceed the interest paid on interest bearing sources of funds. For the purpose of analysis, the interest earned on tax-exempt bonds and municipal loans is adjusted to an amount comparable to interest subject to normal income taxes. This adjustment is referred to as "taxable equivalent" and is noted wherever applicable. Interest income and expense are affected by changes in the volume and mix of average interest earning assets and average interest bearing liabilities, as well as fluctuations in interest rates. Therefore, increases or decreases in net interest income are analyzed as changes in volume, changes in rate/yield and changes in the mix of assets and liabilities. The Company's earning assets and rate sensitive liabilities are subject to repricing at different times, which exposes the Company to income fluctuations when interest rates change. In order to minimize income fluctuations, the Company attempts to match asset and liability maturities. However, some maturity mismatch is inherent in the asset and liability mix. Net interest income increased 14.9% to $13.4 million during the first three months of 2005, compared to $11.6 million at March 31, 2004. On a fully taxable equivalent basis, net interest income increased 15.1% and totaled $13.7 million at March 31, 2005, compared to $11.9 million for the first three months of 2004. As reported in previous quarters, a significant reason for the increase in net interest income during the first three months of 2005 when compared to the same period last year was an improvement in the volume and mix (as reflected by an increase in loans as a percentage of average earning assets) of earning assets. However, as a result of the FRB having increased short-term market interest rates by 175 basis points since June 2004, the Company's net interest income has also started to benefit from an increase in the rate on earning assets. Net interest income on a taxable equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin. For the first quarter of 2005, the Company's net interest margin was 4.93% compared to 4.55% in 2004. This is the fourth quarter in a row that the Company's net interest margin has increased over the same period in the prior year. The Company's yield on earning assets has begun to improve as a result of recent increases in short-term market interest rates as mentioned above. As a result, the Company has increased its prime rate by 175 basis points to 5.75%. Should market interest rates continue to rise, the Company's net interest margin is expected to continue to improve. For further discussion see Market Risk - Interest Rate Risk under Item 3. Quantitative and Qualitative Disclosures About Market Risk. 15 Farmers & Merchants Bancorp Year-to-Date Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands)
Three Months Ended March 31, Three Months Ended March 31, 2005 2004 Assets Balance Interest Rate Balance Interest Rate ------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ 6,837 $ 42 2.49% $ 20,585 $ 52 1.02% Investment Securities Available-for-Sale U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 68,979 620 3.65% 63,061 577 3.71% Municipals - Taxable 327 5 6.20% 1,089 17 6.33% Municipals - Non-Taxable 16,532 259 6.35% 24,021 343 5.79% Mortgage Backed Securities 84,223 832 4.01% 113,393 1,016 3.63% Other 5,068 64 5.12% 7,867 111 5.72% ------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available-for-Sale 175,129 1,780 4.12% 209,431 2,064 4.00% ------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held-to-Maturity U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 20,782 243 4.74% 0 0 0.00% Municipals - Taxable 0 0 0.00% 0 0 0.00% Municipals - Non-Taxable 56,408 876 6.30% 36,301 590 6.59% Mortgage Backed Securities 13,180 126 3.88% 0 0 0.00% Other 294 6 8.28% 372 5 5.45% ------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held-to-Maturity 90,664 1,251 5.60% 36,673 595 6.58% ------------------------------------------------------------------------------------------------------------------------------- Loans Real Estate 494,307 7,713 6.33% 459,385 7,179 6.29% Home Equity 63,301 881 5.64% 55,201 637 4.64% Agricultural 128,835 1,971 6.20% 124,139 1,574 5.10% Commercial 155,550 2,470 6.44% 133,283 1,884 5.69% Consumer 12,248 266 8.81% 11,439 275 9.67% Credit Card 4,896 124 10.27% 4,552 112 9.90% Municipal 982 11 4.54% 1,096 12 4.40% ------------------------------------------------------------------------------------------------------------------------------- Total Loans 860,119 13,436 6.34% 789,095 11,673 5.95% ------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 1,132,749 $16,509 5.91% 1,055,784 $14,384 5.48% ===================== ========================= Unrealized Gain/(Loss) on Securities Available-for-Sal (602) 2,832 Allowance for Loan Losses (17,793) (17,382) Cash and Due From Banks 33,253 31,471 All Other Assets 68,348 60,139 ------------------------------------------------------------------ ------------- Total Assets $1,215,955 $1,132,844 ================================================================== ============= Liabilities & Shareholders' Equity Interest Bearing Deposits Interest Bearing DDA $112,691 $ 19 0.07% $94,147 $ 14 0.06% Savings 308,034 326 0.43% 277,378 256 0.37% Time Deposits 349,749 1,655 1.92% 313,344 1,322 1.70% ------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 770,474 2,000 1.05% 684,869 1,592 0.93% Other Borrowed Funds 47,718 589 5.01% 98,766 716 2.92% Subordinated Debentures 10,310 140 5.51% 10,310 105 4.10% ------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 828,502 $ 2,729 1.34% 793,945 $ 2,413 1.22% ===================== ========================= Interest Rate Spread 4.57% 4.26% Demand Deposits (Non-Interest Bearing) 256,695 217,893 All Other Liabilities 12,933 10,066 ------------------------------------------------------------------ ------------- Total Liabilities 1,098,130 1,021,904 Shareholders' Equity 117,825 110,940 ------------------------------------------------------------------ ------------- Total Liabilities & Shareholders' Equity $1,215,955 $1,132,844 ================================================================== ============= Impact of Non-Interest Bearing Deposits and Other Liabilities 0.36% 0.30% Net Interest Income and Margin on Total Earning Assets 13,780 4.93% 11,971 4.56% Tax Equivalent Adjustment (416) (339) ------------------------------------------------------------------------------------------------------------------------------- Net Interest Income $13,364 4.78% $11,632 4.43% ================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis using the combined Federal and State income tax rate of 42.06%. Loan Fees are included in interest income for loans. Unearned discount is included for rate calculation purposes. Nonaccrual loans and lease financing receivables have been included in the average balances. Yields on securities available-for-sale are based on historical cost. 16 Farmers & Merchants Bancorp Volume and Rate Analysis of Net Interest Revenue (Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Mar.31, 2005 compared to Mar. 31, 2004 Interest Earning Assets Volume Rate Net Chg. ----------------------------------------------------------- ------------- ------------ -------------- Federal Funds Sold $ (194) 184 $ (10) Investment Securities Available for Sale U.S. Treasuries 0 0 0 U.S. Agencies 106 (63) 43 Municipals - Taxable (11) (1) (12) Municipals - Non-Taxable (270) 186 (84) Mortgage Backed Securities (735) 551 (184) Other (36) (11) (47) ----------------------------------------------------------- ------------- ------------ -------------- Total Investment Securities Available for Sale (946) 662 (284) ----------------------------------------------------------- ------------- ------------ -------------- Investment Securities Held to Maturity U.S. Treasuries 0 0 0 U.S. Agencies 121 122 243 Municipals - Taxable 0 0 0 Municipals - Non-Taxable 461 (175) 286 Mortgage Backed Securities 63 63 126 Other (6) 7 1 ----------------------------------------------------------- ------------- ------------ -------------- Total Investment Securities Held to Maturity 639 17 656 ----------------------------------------------------------- ------------- ------------ -------------- Loans: Real Estate 490 44 534 Home Equity 99 145 244 Agricultural 59 338 397 Commercial 327 259 586 Installment 83 (92) (9) Credit Card 8 4 12 Other (3) 2 (1) ----------------------------------------------------------- ------------- ------------ -------------- Total Loans 1,063 700 1,763 ----------------------------------------------------------- ------------- ------------ -------------- Total Earning Assets 562 1,563 2,125 ----------------------------------------------------------- ------------- ------------ -------------- Interest Bearing Liabilities Interest Bearing Deposits: Transaction 3 2 5 Savings 29 41 70 Time Deposits 157 176 333 ----------------------------------------------------------- ------------- ------------ -------------- Total Interest Bearing Deposits 189 219 408 Other Borrowed Funds (1,783) 1,656 (127) Subordinated Debentures 0 35 35 ----------------------------------------------------------- ------------- ------------ -------------- Total Interest Bearing Liabilities (1,594) 1,910 316 ----------------------------------------------------------- ------------- ------------ -------------- Total Change $2,156 $ (347) $ 1,809 =========================================================== ============= ============ ==============
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total "net change." The above figures have been rounded to the nearest whole number. 17 Loans, generally the Company's largest yielding asset, increased $60.0 million as of March 31, 2005 compared to March 31, 2004. On an average balance basis, loans increased by $71.0 million for the three months ended March 31, 2005. The yield on the loan portfolio increased 40 basis points to 6.35% for the three months ended March 31, 2005 compared to 5.95% for the three months ended March 31, 2004. This increase in yield and volume resulted in interest revenue from loans increasing 15.1% to $13.4 million for the first three months of 2005. The investment portfolio is the other main component of the Company's earning assets. In management's opinion the Company's investment policy is conservative. The Company invests primarily in mortgage-backed securities, U.S. Treasuries, U.S. Government Agencies, and high-grade municipals. Since the risk factor for these types of investments is significantly lower than that of loans, the yield earned on investments is generally less than that of loans. Average investment securities increased $19.6 million at March 31, 2005. The average yield, on a taxable equivalent basis, in the investment portfolio was 4.63% in 2005 compared to 4.38% in 2004, partially due to an increase in the mix of longer term, higher yielding municipal securities. The increase in the volume and yield on investment securities resulted in an increase in interest income of $372,000, or 14.0%, for the three months ended March 31, 2005. Net interest income on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on a taxable equivalent basis, which is higher than net interest income on the Consolidated Statements of Income because of adjustments that relate to income on certain securities that are exempt from federal income taxes. Since the first quarter of 2004, the Company has grown average interest-bearing sources of funds by $34.6 million or 4.4%. The increase was driven by lower cost savings and interest bearing DDA deposits, which grew $49.2 million. All other interest bearing sources of funds (including FHLB Advances) decreased by $14.6 million (see Deposits). Overall, the average interest rate on interest-bearing sources of funds was 1.34% for the three months ended March 31, 2005 and 1.22% for the three months ended March 31, 2004. The increase in the volume and rate on interest-bearing sources of funds resulted in an increase in interest expense of $316,000, or 13.1%, for the three months ended March 31, 2005. Allowance and Provision for Loan Losses As a financial institution that assumes lending and credit risks as a principal element of its business, some level of credit losses will be experienced in the normal course of business. The Company manages and controls credit risk through credit management policies and procedures, underwriting and approval standards, dollar limits on loans to one borrower and by restricting loans made primarily to its principal market area where management believes it is better able to assess the applicable risk. Additionally, management has established guidelines to ensure the diversification of the Company's credit portfolio such that even within key portfolio sectors such as real estate or agriculture, the portfolio is diversified across factors such as location, building type, crop type, etc. Management actively monitors the existing portfolio and reports regularly to the Board of Directors regarding trends and conditions in the loan portfolio and regularly conducts credit reviews of individual loans. Loans that are performing but have shown some signs of weakness are subjected to more stringent reporting and oversight. The allowance for loan losses is established to absorb losses inherent in the portfolio. The allowance for loan losses is maintained at a level considered by management to be adequate to provide for losses that are inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. In determining the adequacy of the allowance for loan losses, management takes into consideration many factors including: 18 existing general economic and business conditions affecting the key lending areas of the Company, current levels of problem loans and delinquencies, credit quality trends, collateral values, loan volumes and concentration, seasoning of the loan portfolio, specific industry conditions, recent loss experience, duration of the current business cycle, bank regulatory examination results and findings of the Company's internal credit examiners. The allowance is based on estimates and ultimate losses may vary from the current estimates. Management reviews these estimates periodically and, when adjustments are necessary, they are reported in the period in which they become known. After reviewing the above factors, management concluded that, due to the improvement in non-performing assets (see Non-Performing Assets) from $2.6 million at March 31, 2004 to $510,000 at March 31, 2005, no provision for loan losses was necessary during the first quarter of 2005 and the allowance for loan losses as of March 31, 2005 was adequate. The provision for loan losses for the first quarter of 2004 was $375,000. As of March 31, 2005, the allowance for loan losses was $17.7 million, which represents 2.1% of the total loan balances. As of March 31, 2004 the allowance was $17.6 million or 2.2% of total loans. The following table illustrates the change in the allowance for the first three months of 2005 and 2004. Allowance for Loan Losses (in thousands) Balance, December 31, 2004 $ 17,727 Provision Charged to Expense 0 Recoveries of Loans Previously Charged Off 76 Loans Charged Off (45) ============================================================ Balance, March 31, 2005 $ 17,758 ============================================================ Balance, December 31, 2003 $ 17,220 Provision Charged to Expense 375 Recoveries of Loans Previously Charged Off 31 Loans Charged Off (62) ============================================================ Balance, March 31, 2004 $ 17,564 ============================================================ Non-Interest Income Overall, non-interest income decreased $642,000 or 18.0% for the three months ended March 31, 2005 compared to the same period of 2004. Most of the decrease occurred in gain on sale of investment securities, which was $480,000 less for the first three months of 2005 as compared to the first three months of 2004. During the first three months of 2004 the Company took advantage of a decline in interest rates by selling approximately $29.8 million in investment securities for a gain. The remaining decrease in non-interest income occurred in service charges on deposit accounts due to: (1) the conversion of certain deposit customers to a newly offered high performance checking product that does not have a monthly service charge; (2) increasing interest rates which reduced service charges for those commercial customers on business account analysis; and (3) a decrease in fees generated from money service business relationships as a result of the Company's strategic decision to exit this product line. 19 Non-Interest Expense Overall, non-interest expense increased $601,000 or 6.9% for the first three months of 2005 compared to the first three months of 2004, primarily as a result of a $475,000 increase in Pension Plan expense related to the Company's decision to terminate its Defined Benefit Pension Plan during 2005. This increased level of Pension Plan expense will continue until the plan is terminated during the fourth quarter of 2005. Refer to Note 12 of the Consolidated Financial Statements in the Company's 2004 Annual Report to Shareholders for more information. Another factor impacting non-interest expense was the introduction of a new high performance checking product and the associated direct mail and other ancillary expenses incurred to promote this product. Provision for Income Taxes The provision for income taxes increased 15.2% to $2.5 million for the first three months of 2005. The Company's effective tax rate increased to 36.40% for the first three months of 2005 compared to 36.06% for the same period in 2004. Financial Condition Investment Securities The Financial Accounting Standards Board statement, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its investments as held-to-maturity, trading or available-for-sale. Securities are classified as held-to-maturity and are carried at amortized cost when the Company has the positive intent and ability to hold the securities to maturity. Trading securities are securities acquired for short-term appreciation and are carried at fair value, with unrealized gains and losses recorded in non-interest income. Securities classified as available-for-sale include securities, which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demand and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders' equity, net of related income taxes. The investment portfolio provides the Company with an income alternative to loans. As of March 31, 2005 the investment portfolio represented 22.6% of the Company's total assets. Total investment securities increased $29.6 million from a year ago and now total $275.9 million. Beginning in the fourth quarter of 2004, the Company's asset and liability management strategy called for increasing the size of the Company's longer-term municipal security portfolio. These balances have increased $30.7 million since March 31, 2004. This strategy is intended to provide the Company, which is asset-sensitive, with some protection in the event of a drop in interest rates. For further discussion see Market Risk - Interest Rate Risk under Item 3. Quantitative and Qualitative Disclosures About Market Risk. Not included in the investment portfolio are overnight investments in Federal Funds Sold. For the three months ended March 31, 2005, average Federal Funds Sold was $6.8 million compared to $20.6 million in 2004. Loans The Company's loan portfolio at March 31, 2005 increased $60.0 million from March 31, 2004. The increase was due to strong loan demand in the Company's market area, along with an aggressive calling program on high quality loan prospects. Additionally, on an average balance basis loans have increased $71.0 million or 9.0%. The table following sets forth the distribution of the loan portfolio by type as of the dates indicated. 20 Loan Portfolio As Of:
(in thousands) March 31, 2005 Dec. 31, 2004 March 31, 2004 ---------------------------------------- ------------------------- ---------------------- ------------------------- Real Estate $ 444,529 $431,746 $407,475 Real Estate Construction 54,468 62,446 65,598 Home Equity 61,720 63,782 54,805 Agricultural 125,115 151,002 124,679 Commercial 154,756 142,133 129,804 Consumer 18,478 17,973 16,673 ---------------------------------------- ------------------------- ---------------------- ------------------------- Gross Loans 859,066 869,082 799,034 Less: Unearned Income 2,234 2,174 1,929 Allowance for Loan Losses 17,758 17,727 17,564 ---------------------------------------- ------------------------- ---------------------- ------------------------- Net Loans $ 839,074 $ 849,181 $779,541 ======================================== ========================= ====================== =========================
In the ordinary course of business, the Company enters into commitments to extend credit to its customers. These commitments are not reflected in the accompanying consolidated financial statements. As of March 31, 2005, the Company had entered into commitments with certain customers amounting to $395.6 million compared to $328.3 million at March 31, 2004. Letters of credit at March 31, 2005, and March 31, 2004, were $16.1 million and $12.5 million, respectively. Non-Performing Assets Non-performing assets are comprised of non-performing loans (defined as non-accrual loans plus accruing loans past due 90 days or more) and other real estate owned. As set forth in the table below, non-performing loans as of March 31, 2005 were $510,000 compared to $2.6 million at March 31, 2004. Accrued interest reversed from income on loans placed on a non-accrual status totaled $42,000 at March 31, 2005 compared to $329,000 at March 31, 2004. The Company reported no other real estate owned for both March 31, 2005 and March 31, 2004. Non-Performing Assets
(in thousands) March 31, 2005 December 31, 2004 March 31, 2004 --------------------------------------- ------------------------ ----------------------- ------------------------ Non-performing Loans $510 $225 $2,580 Other Real Estate Owned 0 0 0 ======================================= ======================== ======================= ======================== Total $510 $225 $2,580 ======================================= ======================== ======================= ======================== Non-Performing Assets as a % of Total Loans 0.06% 0.03% 0.3% Allowance for Loan Losses as a % of Non-Performing Loans 3,482.0% 7,878.7% 680.77%
Except for non-performing loans shown in the table above, the Company's management is not aware of any loans as of March 31, 2005 for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their present loan repayment terms, or any known events that would result in the loan being designated as non-performing at some future date. 21 The Company's management cannot, however, predict the extent to which the following or other factors may affect a borrower's ability to pay: 1) deterioration in general economic conditions, real estate values or agricultural commodity prices; 2) increases in interest rates; or 3) changes in the overall financial condition or business of a borrower. Deposits One of the key sources of funds to support earning assets (loans and investments) is the generation of deposits from the Company's customer base. The ability to grow the customer base and subsequently deposits is a significant element in the performance of the Company. At March 31, 2005, deposits totaled $1.0 billion. This represents an increase of 13.6% or $123.4 million from March 31, 2004. The increase was focused in demand and savings deposit accounts, which increased $30.5 million and $33.8 million, respectively. The Company's calling efforts for prospective customers includes acquiring both loan and deposit relationships which results in new demand, interest bearing transaction and savings accounts. Although the Company's time deposits have increased by $38.7 million since March 31, 2004, this growth has been predominantly due to increased use of public time deposits as part of the Company's asset/liability management funding strategies. Due to strong growth in demand, interest bearing transaction and savings balances, the Company has reduced its focus on growing higher cost time deposits; therefore, non-public time deposits have decreased $4.3 million year over year. This reduced reliance on higher cost time deposits has had, and should continue to have, a positive impact on the Company's net interest margin (see Net Interest Income). Federal Home Loan Bank Advances Advances from the Federal Home Loan Bank are another key source of funds to support earning assets. These advances are also used to manage the Company's interest rate risk exposure, and as opportunities exist to borrow and invest the proceeds at a positive spread through the investment portfolio. FHLB advances as of March 31, 2005 were $40.9 million compared to $80.9 million as of March 31, 2004. The Company has reduced its FHLB borrowings by $40 million over the last twelve months and replaced these borrowings with lower cost public time deposits. Long-term Subordinated Debentures On December 17, 2003 the Company raised $10 million through an offering of trust preferred securities. Although this amount is reflected as subordinated debt on the Company's balance sheet, under applicable regulatory guidelines, trust preferred securities qualify as regulatory capital (see Capital). These securities accrue interest at a variable rate based upon 3-month Libor plus 2.85%. Interest rates reset quarterly and were 5.88% as of March 31, 2005. Capital The Company relies primarily on capital generated through the retention of earnings to satisfy its capital requirements. The Company engages in an ongoing assessment of its capital needs in order to support business growth and to insure depositor protection. Shareholders' Equity totaled $119.4 million at March 31, 2005 and $113.5 million at March 31, 2004. The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company and the 22 Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios set forth in the table below of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined in the regulations), and of Tier I capital (as defined in the regulations) to average assets (as defined in the regulations). Management believes, as of March 31, 2005, that the Company and the Bank met all capital adequacy requirements to which they are subject. As of June 30, 2004, the most recent notification from the FRB categorized the Company and the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Company and the Bank must maintain minimum Total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institutions' categories.
To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions The Company: Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ As of March 31, 2005 Total Capital to Risk Weighted Assets $145,310 13.71% $84,800 8.0% N/A N/A Tier I Capital to Risk Weighted Assets $132,003 12.45% $42,400 4.0% N/A N/A Tier I Capital to Average Assets $132,003 10.91% $48,401 4.0% N/A N/A To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions The Bank: Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ As of March 31, 2005 Total Capital to Risk Weighted Assets $141,549 13.37% $ 84,699 8.0% $ 105,874 10.0% Tier I Capital to Risk Weighted Assets $128,251 12.11% $ 42,349 4.0% $ 63,524 6.0% Tier I Capital to Average Assets $128,258 10.63% $ 48,260 4.0% $ 60,325 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to supplement its regulatory capital base, during December, 2003 the Company raised $10 million of trust preferred securities. Under applicable regulatory guidelines, trust preferred securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of trust preferred securities would qualify as Tier 2 capital. The Company has received notification from the Federal Reserve Bank of San Francisco that all of the Company's trust preferred securities currently qualify as Tier 1 capital. In accordance with the provisions of Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), the Company does not consolidate the subsidiary trust which has issued the trust preferred securities. In a March 1, 2005 press release, the FRB issued its final rule concerning the regulatory capital treatment of trust preferred securities by bank holding companies. The final rule closely follows the proposed rule that was released on May 6, 2004 and states that bank holding companies may include trust preferred securities in Tier 1 capital in an amount equal to 25% of the sum of core capital elements net of goodwill, less any associated deferred tax liability. The Company currently has no goodwill or associated deferred tax liability so this requirement does not impact the Company. The effective date of this final rule is April 11, 2005. 23 In 1998, the Board approved the Company's first stock repurchase program which expired on May 1, 2001. During the second quarter of 2004, the Board approved a second stock repurchase program because it concluded that the Company continues to have more capital than it needs to meet present and anticipated regulatory guidelines to be classified as "well capitalized". Repurchases under the second program will be made on the open market or through private transactions. The aggregate price to be paid by the Company for all repurchased stock will not exceed $10,000,000 and the program will expire on May 31, 2007. The repurchase program also requires that no purchases may be made if the Company would not remain "well-capitalized" after the repurchase. All shares repurchased under the repurchase program will be retired (see Part II, Item 2. Unregistered Sales of Securities and Use of Proceeds). Since 1999, the Company has repurchased over 44,000 shares for total consideration of $11.7 million, including 13 shares during the first quarter of 2005 at an average price of $425 per share. Critical Accounting Policies and Estimates This "Management's Discussion and Analysis of Financial Condition and Results of Operations," is based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the Company's financial statements management makes estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These judgments govern areas such as the allowance for loan losses, the fair value of financial instruments, accounting for income taxes and pension accounting. For a full discussion of the Company's critical accounting policies and estimates see "Management's Discussion and Analysis" in the Company's Annual Report to Shareholders for the year ended December 31, 2004. Off Balance Sheet Arrangements Off-balance sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by the Company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company. For a full discussion of the Company's off balance sheet arrangements, see the Notes to the Consolidated Financial Statements in the Company's 2004 Annual Report to Shareholders. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Risk Management The Company has adopted a Risk Management Plan to provide for the proper control and management of risk factors inherent in the operation of the Company. Specifically, credit risk, interest rate risk, liquidity risk, compliance risk, strategic risk, and reputation risk can all affect the market risk of the Company. These specific risk factors are not mutually exclusive. It is recognized that any product or service offered by the Company may expose the Company to one or more of these risk factors. 24 Credit Risk Credit risk is the risk to earnings or capital arising from an obligor's failure to meet the terms of any contract or otherwise fail to perform as agreed. Credit risk is found in all activities where success depends on counterparty, issuer or borrower performance. Credit risk in the investment portfolio is addressed through defined limits in the Company's policy statements. The Company's investment policy is conservative. The Company invests primarily in mortgage-backed securities, U.S. Treasuries, U.S. Government Agencies, and high-grade municipals. Additionally, most municipal securities carry insurance to enhance the credit quality of the bond. The Company manages and controls credit risk in the loan portfolio through credit management policies and procedures, underwriting and approval standards, dollar limits on loans to one borrower and by restricting loans made primarily to its principal market area where management believes it is better able to assess the applicable risk. Additionally, management has established guidelines to ensure the diversification of the Company's credit portfolio such that even within key portfolio sectors such as real estate or agriculture, the portfolio is diversified across factors such as location, building type, crop type, etc. Management actively monitors the existing portfolio and reports regularly to the Board of Directors regarding trends and conditions in the loan portfolio and regularly conducts credit reviews of individual loans. Loans that are performing but have shown some signs of weakness are subjected to more stringent reporting and oversight. As a financial institution which assumes lending and credit risks as a principal element in its business, the Company anticipates that credit losses will be experienced in the normal course of business. Accordingly, an allowance for loan losses is maintained at a level considered adequate by management to provide for losses that are inherent in the portfolio. The allowance is increased by provisions charged to operating expense and by recoveries on loans previously charged-off and reduced by charge-offs. Management employs a systematic methodology for determining the allowance for loan losses. On a quarterly basis, management reviews the credit quality of the loan portfolio and considers many factors in determining the adequacy of the allowance balance. Central to the Company's evaluation of the adequacy of the allowance for loan losses is its loan risk rating system. The originating credit officer assigns borrowers an initial risk rating, which is based primarily on a thorough analysis of each borrower's financial position in conjunction with industry and economic trends. Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior credit administration personnel. Credits are monitored by credit administration personnel for deterioration in a borrower's financial condition, which would impact the ability of the borrower to perform under the contract. Risk ratings are adjusted as necessary. Based on the risk rating system specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicates the possibility of loss. Management performs a detailed analysis of these loans, including, but not limited to, cash flows, appraisals of the collateral, conditions of the marketplace for liquidating the collateral and assessment of the guarantors. Management then determines the inherent loss potential and allocates a portion of the allowance for losses as a specific allowance for each of these credits. The Company also segments the loan portfolio by risk rating and into groups of loans with similar characteristics in accordance with SFAS No. 5, "Accounting for Contingencies". During this process groups of loans are reviewed and applied the appropriate allowance percentage to determine a portfolio formula allowance. 25 Finally, the Company's methodology for assessing the appropriateness of the allowance involves management's consideration of all known relevant internal and external factors that may affect a loan's collectibility. The factors evaluated in connection with the allowance may include existing general economic and business conditions affecting the key lending areas of the Company, current levels of problem loans and delinquencies, credit quality trends, collateral values, loan volumes and concentration, seasoning of the loan portfolio, specific industry conditions, recent loss experience, duration of the current business cycle, bank regulatory examination results and findings of the Company's internal credit examiners. While the Company utilizes a systematic methodology in determining its allowance, the allowance is based on estimates, and ultimate losses may vary from current estimates. The estimates are reviewed periodically and, as adjustments become necessary, are reported in earnings in the periods in which they become known. Management believes that the allowance for loan losses at March 31, 2005 was adequate to provide for losses inherent in the portfolio. No assurances can be given that future events may not result in increases in delinquencies, non-performing loans or net loan charge-offs that would increase the provision for loan losses and thereby adversely affect the results of operations. Interest Rate Risk The mismatch between maturities of interest sensitive assets and liabilities results in uncertainty in the Company's earnings and economic value and is referred to as interest rate risk. The Company's primary objective in managing interest rate risk is to minimize the potential for significant loss as a result of changes in interest rates. The Company measures interest rate risk in terms of the potential impact on both its economic value and earnings. Methods for analyzing interest rate risk include: (1) asset/liability mismatch ("GAP") analysis; (2) earnings simulation model; and (3) economic value of equity ("EVE") analysis. The Company's GAP analysis measures, at specific time intervals, the divergence between earning assets and interest bearing liabilities for which repricing opportunities will occur. A positive difference, or Gap, indicates that earning assets will reprice faster than interest-bearing liabilities. This will generally produce a greater net interest margin during periods of rising interest rates and a lower net interest margin during periods of declining interest rates. Conversely, a negative gap will generally produce a lower net interest margin during periods of rising interest rates and a greater net interest margin during periods of decreasing interest rates. The interest rates paid on deposit accounts do not always move in unison with the rates charged on loans. In addition, the magnitude of changes in the rates charged on loans is not always proportionate to the magnitude of changes in the rate paid for deposits. Consequently, changes in interest rates do not necessarily result in an increase or decrease in the net interest margin solely as a result of the differences between repricing opportunities of earning assets or interest bearing liabilities. The Company's earnings simulation model quantifies the estimated exposure to net interest income of sustained interest rate changes. The sensitivity of the Company's net interest income is measured over a rolling one-year horizon. 26 The simulation model estimates the impact of changing interest rates on interest income from all interest earning assets and the interest expense paid on all interest bearing liabilities reflected on the Company's balance sheet. This sensitivity analysis is compared to policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon assuming no balance sheet growth, given a 200 basis point upward and a 100 basis point downward shift in interest rates. A shift in rates over a 12-month period is assumed. Results that exceed policy limits, if any, are analyzed for risk tolerance and reported to the Board with appropriate recommendations. At March 31, 2005, the Company's estimated net interest income sensitivity to changes in interest rates, as a percent of net interest income was an increase in net interest income of 2.90% if rates increase by 200 basis points and a decrease in net interest income of 2.29% if rates decline 100 basis points. The estimated sensitivity does not necessarily represent a Company forecast and the results may not be indicative of actual changes to the Company's net interest income. These estimates are based upon a number of assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, pricing strategies on loans and deposits, replacement of asset and liability cashflows, and other assumptions. While the assumptions used are based on current economic and local market conditions, there is no assurance as to the predictive nature of these conditions including how customer preferences or competitor influences might change. See Note 13 of the Notes to the Consolidated Financial Statements located in the 2004 Annual Report to Shareholders. The Company's EVE analysis measures the present value of the Company's assets, less the present value of its liabilities, +/- the net present value of any off-balance sheet items. This analysis is compared to policy limits, which specify a maximum tolerance level the Company has established based on the Summary Guidelines found in Thrift Bulletin 13a. Liquidity Risk Liquidity risk is the risk to earnings or capital resulting from the Company's inability to meet its obligations when they come due without incurring unacceptable losses. It includes the ability to manage unplanned changes in funding sources and to recognize or address changes in market conditions that affect the Company's ability to liquidate assets or acquire funds quickly and with minimum loss of value. The Company endeavors to maintain a cash flow adequate to fund operations, handle fluctuations in deposit levels, respond to the credit needs of borrowers and take advantage of investment opportunities as they arise. The principal sources of liquidity include credit facilities from correspondent banks, brokerage firms and the Federal Home Loan Bank, as well as, interest and principal payments on loans and investments, proceeds from the maturity or sale of investments, and growth in deposits. In general, liquidity risk is managed daily by controlling the level of Federal Funds (either purchased or sold) to supplement the cash flows received from operating, investing and other financing activities (see Consolidated Statement of Cash Flows). During the first quarter of 2005, Federal Funds sold averaged $6.8 million and Federal Funds purchased averaged $3.1 million. The Company maintains Federal Fund credit lines of $50 million with major banks subject to the customary terms and conditions for such arrangements and $175 million in repurchase lines with major brokers. In addition the Company has additional borrowing capacity of $195.3 million from the Federal Home Loan Bank. At March 31, 2005, the Company had available liquid assets, which included cash and cash equivalents and unpledged investment securities of approximately $131.3 million, which represents 10.7% of total assets. 27 ITEM 4. CONTROLS AND PROCEDURES The Company maintains controls and procedures designed to ensure that information is recorded and reported in all filings of financial reports. Such information is reported to the Company's management, including its Chief Executive Officer and its Chief Financial Officer to allow timely and accurate disclosure based on the definition of "disclosure controls and procedures" in Rule 13a-15(e). In designing these controls and procedures, management recognizes that they can only provide reasonable assurance of achieving the desired control objectives. Management also evaluated the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation of the effectiveness of Company's controls and disclosure procedures under the supervision and with the participation of the Chief Executive Officer, the Chief Financial Officer and other senior management of the Company. Based on the foregoing, the Company's Chief Executive Officer and the Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against the Company or its subsidiaries. Based upon information available to the Company, its review of such lawsuits and claims and consultation with its counsel, the Company believes the liability relating to these actions, if any, would not have a material adverse effect on its consolidated financial statements. There are no material proceedings adverse to the Company to which any director, officer or affiliate of the Company is a party. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds The following table indicates the number of shares repurchased by Farmers & Merchants Bancorp during the first quarter of 2005.
Number of Shares Approximate Dollar Value Average Purchased as Part of a of Shares that May Yet Be Number of Price per Publicly Announced Purchased Under the Plan First Quarter 2004 Shares Share Plan or Program or Program ------------------------------- ---------------- -------------- ------------------------ --------------------------- 01/01/2005 - 01/31/2005 $13 $425 13 $7,895,000 02/01/2005 - 02/29/2005 0 0 0 7,895,000 03/01/2005 - 03/31/2005 0 0 0 7,895,000 ------------------------------- ---------------- -------------- ------------------------ --------------------------- Total 13 $425 13 $7,895,000
All of the above shares were repurchased in private transactions. 28 The common stock of Farmers & Merchants Bancorp is not widely held, is not listed on any exchange, nor is it included on the NASDAQ National Market or the NASDAQ Small Cap Market. However, trades may be reported on the OTC Bulletin Board under the symbol "FMCB.OB". Additionally, management is aware that there are private transactions in the Company's common stock. ITEM 3. Defaults Upon Senior Securities Not applicable ITEM 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of the Company's stockholders during the first quarter of 2005. ITEM 5. Other Information On May 3, 2005, the Board of Directors of the Bank adopted a 2005 Deferred Bonus Plan and an Executive Retention Plan. These Plans are filed as exhibits to this report. Since the distribution of the proxy statement for the 2005 annual meeting of stockholders, there have been no material changes to the procedures by which stockholders may recommend nominees to the Company's Board of Directors. ITEM 6. Exhibits See Exhibit Index on Page 31. 29 SIGNATURES Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FARMERS & MERCHANTS BANCORP Date: May 6, 2005 /s/ Kent A. Steinwert -------------------------- Kent A. Steinwert President and Chief Executive Officer (Principal Executive Officer) Date: May 6, 2005 /s/ Stephen W. Haley -------------------------- Stephen W. Haley Executive Vice President and Chief Financial Officer (Principal Accounting Officer) 30 Index to Exhibits Exhibit No. Description 10.15 2005 Deferred Bonus Plan of Farmers & Merchants Bank of Central California executed May 3, 2005. 10.16 Executive Retention Plan of Farmers & Merchants Bank of Central California executed May 3, 2005. 31(a) Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31(b) Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 31