-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, EjPAEyUuR7clypztv1Uh/0F/nmfgOB6iVEDVp0dzPVvsN0qWRnaidFeXFc3gxPDR xSRoCZ6PdaGVb2ZAOZ7S5w== 0000950137-04-006728.txt : 20040813 0000950137-04-006728.hdr.sgml : 20040813 20040813110213 ACCESSION NUMBER: 0000950137-04-006728 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040630 FILED AS OF DATE: 20040813 FILER: COMPANY DATA: COMPANY CONFORMED NAME: BAYLAKE CORP CENTRAL INDEX KEY: 0000275119 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 391268055 STATE OF INCORPORATION: WI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-16339 FILM NUMBER: 04972324 BUSINESS ADDRESS: STREET 1: 217 N FOURTH AVE STREET 2: PO BOX 9 CITY: STURGEON BAY STATE: WI ZIP: 54235-0009 BUSINESS PHONE: 9207435551 10-Q 1 c87578e10vq.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q {X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 -------------------------------------------------- OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------------------ ---------------------- Commission file number 0-8679 -------------------------------------------------------- BAYLAKE CORP. - ------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Wisconsin 39-1268055 - ------------------------------------------------------------------------------- (State or other jurisdiction of incorporation (Identification No.) or organization) 217 North Fourth Avenue, Sturgeon Bay, WI 54235 - ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (920)-743-5551 - ------------------------------------------------------------------------------- (Registrant's telephone number, including area code) None - ------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) 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 Act). Yes X No --- --- Applicable Only to Corporate Issuers: Number of outstanding shares of each of common stock, par value $5.00 per share, as of August 12, 2004: 7,653,277 shares BAYLAKE CORP. AND SUBSIDIARIES INDEX
PART 1 - FINANCIAL INFORMATION PAGE NUMBER Item 1. Financial Statements Consolidated Condensed Balance Sheet as of June 30, 2004 3 - 4 and December 31, 2003 Consolidated Condensed Statement of Income for the three 5 - 6 and six months ended June 30, 2004 and 2003 Consolidated Statement of Comprehensive Income for the three 7 and six months ended June 30, 2004 and 2003 Consolidated Statement of Cash Flows for the six months ended 8 - 9 June 30, 2004 and 2003 Notes to Consolidated Condensed Financial Statements 10 -11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 -34 Item 3. Quantitative and Qualitative Disclosures About Market Risk 34 -35 Item 4. Controls and Procedures 35 PART II - OTHER INFORMATION 36 Item 1. Legal Proceedings 36 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 36 Item 3. Defaults Upon Senior Securities 36 Item 4. Submission of Matter to a Vote of Security Holders 36 Item 5. Other Information 36 Item 6. Exhibits and Reports on Form 8-K 37 Signatures 37 EXHIBIT INDEX 37 Exhibit 31.1 Certification pursuant to Section 302 38 Exhibit 31.2 Certification pursuant to Section 302 39 Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 40 Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 41
2 PART 1 - FINANCIAL INFORMATION BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEET (UNAUDITED) (dollars in thousands)
JUNE 30 DECEMBER 31, 2004 2003 ------------- ------------- ASSETS Cash and due from banks $ 20,180 $ 24,226 Federal funds sold 0 0 ------------- ------------- Cash and cash equivalents 20,180 24,226 Investment securities available for sale (at market) 182,150 176,815 Investment securities held to maturity (market value $17,378 and $19,314 at June 30, 2004 and December 31, 2003, respectively) 17,284 19,032 Loans held for sale 0 165 Loans 724,613 695,990 Less: Allowance for loan losses 13,080 12,159 ------------- ------------- Loan, net of allowance for loan losses 711,533 683,831 Bank premises and equipment 23,891 21,958 Federal Home Loan Bank stock (at cost) 7,473 7,247 Accrued interest receivable 4,325 3,959 Income taxes receivable 0 636 Deferred income taxes 4,433 3,148 Goodwill 4,969 4,969 Other Assets 30,948 29,252 ------------- ------------- Total Assets $ 1,007,186 $ 975,238 ============= ============= LIABILITIES Domestic deposits Non-interest bearing $ 105,266 $ 106,642 Interest bearing NOW 90,189 92,308 Savings 192,475 204,252 Time, $100,000 and over 205,521 180,568 Other time 186,174 199,522 ------------- ------------- Total interest bearing 674,359 676,650 ------------- ------------- Total deposits 779,625 783,292 Short-term borrowings Federal funds purchased, repurchase agreements and Federal Home Loan Bank advances 33,578 23,359 Accrued expenses and other liabilities 6,935 6,155 Dividends payable 0 1,061 Other borrowings 100,195 75,092 Long-term debt 0 53
3 Junior subordinated debentures issued to unconsolidated subsidiary trust 16,598 16,598 ------------- ------------- Total liabilities 936,931 905,610 ------------- ------------- STOCKHOLDERS' EQUITY Common stock, $5 par value: authorized 50,000,000 shares; issued 7,676,436 shares as of June 30, 2004 and 7,628,135 as of December 31, 2003; outstanding 7,653,277 as of June 30, 2004 and 7,604,976 as of December 31, 2003 38,382 38,141 Additional paid-in capital 8,511 8,163 Retained earnings 24,217 21,864 Treasury Stock (625) (625) Net unrealized gain (loss) on securities available for sale, net of tax of ($190) as of June 30, 2004 and $1,094 as of December 31, 2003 (230) 2,085 ------------- ------------- Total stockholders' equity 70,255 69,628 ------------- ------------- Total liabilities and stockholders' equity $ 1,007,186 $ 975,238 ============= =============
4 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (dollars in thousands, except per share amounts)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 2004 2003 2004 2003 ------------- ------------- ------------- ------------- Interest income Interest and fees on loans $ 10,070 $ 10,194 $ 19,802 $ 20,390 Interest on investment securities Taxable 1,638 1,053 3,214 2,104 Exempt from federal income taxes 527 608 1,077 1,253 Other interest income 4 9 7 15 ------------- ------------- ------------- ------------- Total interest income 12,239 11,864 24,100 23,762 Interest expense Interest on deposits 2,810 3,977 5,828 8,073 Interest on short-term borrowings 110 26 222 50 Interest on other borrowings 544 553 1,023 1,108 Interest on long-term debt 0 1 0 2 Interest on junior subordinated debentures of unconsolidated subsidiary 423 411 847 822 ------------- ------------- ------------- ------------- Total interest expense 3,887 4,968 7,920 10,055 ------------- ------------- ------------- ------------- Net interest income 8,352 6,896 16,180 13,707 Provision for loan losses 724 1,032 1,499 1,925 ------------- ------------- ------------- ------------- Net interest income after provision for loan losses 7,628 5,864 14,681 11,782 ------------- ------------- ------------- ------------- Other income Fees from fiduciary activities 188 159 362 293 Fees from loan servicing 282 600 620 1,062 Fees for other services to customers 1,105 1,025 2,075 2,099 Gains from sales of loans 269 618 482 1,043 Gains from sale of subsidiary 0 0 0 350 Other income 831 342 1,118 541 ------------- ------------- ------------- ------------- Total other income 2,675 2,744 4,657 5,388 ------------- ------------- ------------- ------------- Other expenses Salaries and employee benefits 3,944 3,645 7,809 7,346 Occupancy expense 529 478 1,051 947 Equipment expense 299 423 668 816 Data processing and courier 272 266 555 538 Operation of other real estate 146 34 271 137 Other operating expenses 1,322 1,233 2,530 2,327 ------------- ------------- ------------- ------------- Total other expenses 6,512 6,079 12,884 12,111 ------------- ------------- ------------- ------------- Income before income taxes 3,791 2,529 6,454 5,059 Income tax expense 1,198 662 1,965 1,366 ------------- ------------- ------------- -------------
5 Net Income $ 2,593 $ 1,867 $ 4,489 $ 3,693 ============= ============= ============= ============= Basic earnings per common share (1) $ 0.34 $ 0.25 $ 0.59 $ 0.49 Diluted earnings per common share (1) $ 0.33 $ 0.24 $ 0.58 $ 0.48 Cash dividends per share $ 0.14 $ 0.13 $ 0.28 $ 0.26
(1) Based on 7,625,818 average shares outstanding in 2004 and 7,506,591 in 2003. 6 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED) (dollars in thousands)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Net Income $ 2,593 $ 1,867 $ 4,489 $ 3,693 ------------ ------------ ------------ ------------ Other comprehensive income, net of tax: Unrealized gains (losses) on securities: Unrealized gains (losses) arising during period (3,725) 988 (2,315) 835 ------------ ------------ ------------ ------------ Comprehensive income $ (1,132) $ 2,855 $ 2,174 $ 4,528 ============ ============ ============ ============
7 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED) (dollars in thousands)
SIX MONTHS ENDED JUNE 30 2004 2003 ------------- ------------- Cash flows from operating activities: Interest received from: Loans $ 19,635 $ 20,137 Investments 4,550 4,040 Fees and service charges 3,485 4,473 Interest paid to depositors (6,030) (8,164) Interest paid to others (2,064) (1,998) Cash paid to suppliers and employees (12,491) (14,441) Income taxes paid (781) (1,569) ------------- ------------- Net cash provided by operating activities 6,304 2,478 Cash flows from investing activities: Principal payments received on investments 17,013 42,188 Purchase of investments (24,681) (45,002) Proceeds from sale of other real estate owned 1,170 1,304 Proceeds from sale of subsidiary's assets 0 1,884 Loans made to customers in excess of principal collected (30,680) (15,181) Capital expenditures (2,166) (775) ------------- ------------- Net cash used in investing activities (39,344) (15,582) Cash flows from financing activities: Net increase (decrease) in demand deposits, NOW accounts, and savings accounts (15,373) 8,386 Net increase (decrease) in short term borrowing 10,219 (4,124) Net increase (decrease) in time deposits 11,705 (792) Proceeds from other borrowings and long-term debt 25,103 0 Payments on other borrowings and long term debt (53) (53) Net proceeds from exercise of stock options issued pursuant to plan 590 525 Dividends paid (3,197) (2,925) ------------- ------------- Net cash provided by financing activities 28,994 1,017 ------------- ------------- Net decrease in cash and cash equivalents (4,046) (12,087) Cash and cash equivalents, beginning 24,226 33,300 ------------- ------------- Cash and cash equivalents, ending $ 20,180 $ 21,213 ============= =============
8
SIX MONTHS ENDED JUNE 30 2004 2003 ------------- ------------- Reconciliation of net income to net cash provided by operating activities: Net income $ 4,489 $ 3,693 Adjustments to reconcile net income to net cash provided by operating Activities: Depreciation 715 871 Provision for losses on loans and real estate owned 1,499 1,925 Amortization of premium on investments 320 474 Accretion of discount on investments (64) (85) Cash surrender value increase (391) (336) (Gain) Loss from disposal of ORE (64) (25) Gain on sale of loans (482) (1,043) Proceeds from sale of loans held for sale 32,189 82,185 Originations of loans held for sale (31,707) (81,142) Gain from disposal of fixed assets (482) 0 Gain on sale of subsidiary 0 (350) Equity in income of service center (155) (135) Amortization of core deposit intangible 30 0 Amortization of mortgage servicing rights 132 185 Mortgage servicing rights booked (143) (259) Deferred compensation 130 210 Changes in assets and liabilities: Interest receivable (366) 35 Prepaids and other assets (828) (3,119) Unearned income 195 (8) Interest payable (174) (106) Taxes payable 1,184 (203) Other liabilities 277 (289) ------------- ------------- Total adjustments 1,815 (1,215) ------------- ------------- Net cash provided by operating activities $ 6,304 $ 2,478 ============= =============
9 BAYLAKE CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2004 1. The accompanying consolidated financial statements should be read in conjunction with Baylake Corp.'s 2003 annual report on Form 10-K. The accompanying consolidated financial statements are unaudited. In the opinion of management, the unaudited financial information included in this report reflects all adjustments, consisting only of normal recurring accruals, which are necessary for a fair statement of the financial position as of June 30, 2004 and December 31, 2003. The results of operations for the three and six months ended June 30, 2004 and 2003 are not necessarily indicative of results to be expected for the entire year. 2. The book value of investment securities, by type, held by Baylake Corp. are as follows:
JUNE 30, DECEMBER 31, 2004 2003 ------------- ------------- (dollars in thousands) Investment securities held to maturity: Obligations of state and political subdivisions $ 17,284 $ 19,032 ------------- ------------- Investment securities held to maturity $ 17,284 $ 19,032 ============= ============= Investment securities available for sale: U.S. Treasury and other U.S. government agencies $ 47,859 $ 39,696 Obligations of states and political subdivisions 31,602 35,015 Mortgage-backed securities 99,052 99,148 Other 3,637 2,956 ------------- ------------- Investment securities available for sale $ 182,150 $ 176,815 ============= =============
3. At June 30, 2004 and December 31, 2003, loans were as follows:
JUNE 30, DECEMBER 31, 2004 2003 ------------- ------------- (dollars in thousands) Commercial, financial and agricultural $ 89,718 $ 91,009 Real estate-commercial 410,953 387,820 Real estate - construction 81,022 77,350 Real estate - mortgage 129,816 125,700 Installment 13,649 14,460 Less: Deferred loan origination fees, net of costs (545) (349) ------------- ------------- $ 724,613 $ 695,990 Less allowance for loan losses (13,080) (12,159) ------------- ------------- Net loans $ 711,533 $ 683,831 ============= =============
10 4. Baylake Corp. declared a cash dividend of $0.14 per share payable on June 15, 2004 to shareholders of record as of June 1, 2004. 5. Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options were exercised and stock awards were fully vested and resulted in the issuance of common stock that then shared in the earnings of the Company, is computed by dividing net income by weighted average number of common shares and common stock equivalents. The following table shows the computation of the basic and diluted earnings per share for the six months ended June 30 (dollars in thousands, except per share amounts):
Weighted average number Earnings Net income of shares per share ------------- -------------- ------------- 6/30/04 Earnings per share, basic $ 4,489 7,625,818 $ 0.59 Effect of stock options-net 115,183 ----------- Earnings per share, diluted $ 4,489 7,741,001 $ 0.58 6/30/03 Earnings per share, basic $ 3,693 7,506,591 $ 0.49 Effect of stock options-net 122,029 ----------- Earnings per share, diluted $ 3,693 7,628,620 $ 0.48
6. The Company has a non-qualified stock option plan, which is described more fully in the Company's December 31, 2003 Annual Report on Form 10-K. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under these plans had an exercise price at least equal to the fair market value of the underlying common stock on the grant date. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of SFAS 123 "Accounting for Stock-Based Compensation," to stock-based employee compensation.
Three months ended June 30, Six months ended June 30, ------------------------------ ------------------------------ (In thousands, except per share amounts) 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Net income, as reported $ 2,593 $ 1,867 $ 4,489 $ 3,693 ------------ ------------ ------------ ------------ Less: Total stock-based employee compensation cost determined under the fair value based method, net of income taxes (47) (114) (93) (158) ------------ ------------ ------------ ------------ Pro forma net income 2,546 1,753 4,396 3,535 Earnings per share: Basic - as reported $ 0.34 $ 0.25 $ 0.59 $ 0.49 Basic - pro forma $ 0.33 $ 0.23 $ 0.58 $ 0.47 Diluted - as reported $ 0.33 $ 0.24 $ 0.58 $ 0.48 Diluted - pro forma $ 0.33 $ 0.23 $ 0.57 $ 0.47
11 PART 1 - FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following sets forth management's discussion and analysis of the consolidated financial condition and results of operations of Baylake Corp. ("Baylake" or the "Company") for the three and six months ended June 30, 2004 and 2003 which may not be otherwise apparent from the consolidated financial statements included in this report. Unless otherwise stated, the "Company" or "Baylake" refers to this entity and to its subsidiaries on a consolidated basis when the context indicates. For a more complete understanding, this discussion and analysis should be read in conjunction with the financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report. In 1998, the Company acquired Evergreen Bank, N.A. ("Evergreen"), which was later merged into Baylake Bank. In the acquisition as a result of Evergreen's capital regulatory condition, the Company was required to contribute capital to Evergreen, but no payment to the seller of Evergreen was made by the Company and no payments are presently due. However, the Company is obligated for certain contingent payments that may become payable in the future, not to exceed $2 million. Such contingent payments are not accrued at June 30, 2004, since that amount, if any, is not estimable. Forward-Looking Information This discussion and analysis of financial condition and results of operations, and other sections of this report, may contain forward-looking statements that are based on the current expectations of management. Such expressions of expectations are not historical in nature and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "projects," and other such words are intended to identify in such forward-looking statements. The statements contained herein and in such forward-looking statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the control of the Company, that may cause actual future results to differ materially from what may be expressed or forecasted in such forward-looking statements. Readers should not place undue expectations on any forward-looking statements. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the relationships; demand for financial products and financial services; the degree of competition by traditional and non-traditional financial services competitors; changes in banking legislation or regulations; changes in tax laws and the results of recent Wisconsin state tax developments; changes in interest rates; changes in prices; the impact of technological advances; governmental and regulatory policy changes; trends in customer behavior as well as their ability to repay loans; and changes in the general economic conditions, nationally or in the State of Wisconsin. Critical Accounting Policies In the course of the Company's normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in the consolidated financial statements of the Company. Some of these policies are more critical than others. Allowance for Loan Losses: Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy because of the uncertainty and subjectivity inherent in estimating the levels of allowance needed to cover probable credit losses within the loan portfolio and the 12 material effect that these estimates can have on the Company's results of operations. While management's evaluation of the allowance for loan losses as of June 30, 2004 considers the allowance to be adequate, under adversely different conditions or assumptions, the Company would need to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Company's non-performing loans and potential problem loans, as well as the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Though management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluation were significantly lowered, the Company's allowance for loan losses policy would also require making additional provisions for loan losses. Management reviews the adequacy of the Allowance for Loan Losses ("allowance" or "ALL") on a quarterly basis to determine whether, in management's estimate, the allowance is adequate to provide for possible losses inherent in the loan portfolio as of the balance sheet date. Management's evaluation of the adequacy of the ALL is based primarily on management's periodic assessment and grading of the loan portfolio as described below. Additional factors considered by management include the consideration of past loan loss experience, trends in past due and non-performing loans, risk characteristics of the various classifications of loans, current economic conditions, the fair value of underlying collateral, and other regulatory or legal issues that could affect credit losses. Loans are initially graded when originated. They are re-graded as they are renewed, when there is a loan to the same borrower, when identified facts demonstrate heightened risk of nonpayment, or if they become delinquent. The loan review, or, grading process attempts to identify and measure problem and watch list loans. Problem loans are those loans that management determines have a higher than average risk for default, with workout and/or legal action probable within one year. These loans are reported at least quarterly to the directors' loan committee and reviewed at the officers' loan committee for action to be taken. Watch list loans are those loans considered as having weakness detected in either character, capacity to repay or balance sheet concerns and prompt management to take corrective action at the earliest opportunity. Problem and watch list loans generally exhibit one or more of the following characteristics: 1. Adverse financial trends and condition 2. Decline in the entire industry 3. Managerial problems 4. Customer's failure to provide financial information or other collateral documentation 5. Repeated delinquency, overdrafts or renewals Every significant problem credit is reviewed by the loan review process and assessments are performed quarterly to confirm the risk rating, proper accounting and the adequacy of loan loss reserve assigned. In addition to this quarterly management review, all problem loans are monitored and evaluated on a monthly basis by a designated review committee. Depending on the change in condition, loans may be reassessed concerning allocation of risk, probable disposition, and potential loss, including changes to the ALL. After reviewing the gradings in the loan portfolio, management will allocate or assign a portion of the ALL to categories of loans and individual loans to cover management's estimate of probable loss. Allocation is related to the grade of the loan and includes a component resulting from the application of the measurement criteria of Statements of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114") and No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures" ("SFAS 118"). Allocations also are made for unrated loans, such as credit card loans, based on historical loss experience adjusted for portfolio activity. The indirect risk in the form of off-balance sheet unfunded commitments are also taken into consideration. These allocated reserves are further supplemented by unallocated reserves based on management's estimate regarding risk of error, local economic conditions and any other relevant factors. Management then compares the amounts allocated for probable losses to the current allowance. To the extent that the current allowance is insufficient to cover management's best estimate of probable losses, management records additional 13 provision for credit loss. If the allowance is greater than required at that point in time, provision expense is adjusted accordingly. Mortgage servicing rights: Another valuation that requires management's judgment relates to mortgage servicing rights. Essentially, mortgage servicing rights are established on residential mortgage loans and guaranteed commercial loans that the Company originate and sell. A portion of the loan's book basis is allocated to mortgage servicing rights which are retained when a loan is sold, based upon its relative fair value. The fair value of mortgage servicing rights is the present value of estimated future net cash flows from the servicing relationship using current market assumptions for prepayments, servicing costs and other factors. As the loans are repaid and net servicing revenue is earned, mortgage servicing rights are amortized against servicing revenue. Net servicing rights are expected to exceed this amortization expense. However, if the actual prepayment experience exceeds what was originally anticipated, net servicing revenues may be less than expected and mortgage servicing rights may be impaired. This impairment would be recorded as a charge to earnings in the period in which it became impaired. Core deposit intangibles: Judgment is used in the valuation of other intangible assets such as core deposit base intangibles. Core deposit base intangibles assets of $361,000 have been recorded for core deposits (defined as checking, money market, savings and time deposits) that have been acquired as a result of a branch acquisition. The core deposit base intangible assets have been recorded using the assumption in 2003 that they provide a more favorable source of funding than more expensive wholesale borrowings. An intangible asset has been recorded for the present value of the difference between the expected interest expense to be incurred on these deposits and interest expense that would be expected if these deposits were replaced by wholesale borrowings, over the expected lives of the core deposits. The Company currently estimates that the underlying core deposits have lives of seven years. If future analysis shows these deposits to have a shorter life, then the Company will write down the asset by expensing the amount that is impaired. Goodwill: The Company has goodwill assets on the books as a result of two prior acquisitions. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible assets with indefinite lives no longer be amortized, but instead tested for impairment as least annually. SFAS No. 142 requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and be reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Those tests inherently involve management's judgment as to factors such as an estimation of the fair value of a reporting unit; screening for potential impairment and measuring the amount of the impairment. There was no impairment of goodwill in 2003 or to date in 2004. In the event of goodwill impairment, that amount would be charged to earnings in the period in which the impairment is determined. Income tax accounting: The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management's current assessment, the impact of which could be significant to the consolidated results of the Company's operations and reported earnings. The Company believes that the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. The reserve does not include any specific reserves relative to any position recently taken by the taxing authorities. See Section on "Results of Operations-Income Taxes." Results of Operations For the three months ended June 30, 2004, earnings increased $726,000, or 38.9%, to $2.6 million from $1.9 million for the second quarter last year. Basic and fully diluted earnings per share of $0.34 and $0.33, respectively, were reported for the quarter ended June 30, 2004 compared to $0.25 and $0.24, respectively, for the same period last year. For the six months ended June 30, 2004, earnings increased $796,000, or 14 21.6%, to $4.5 million from $3.7 million for the same period in 2003. Basic and fully diluted earnings per share of $0.59 and $0.58, respectively, were reported for the six months ended June 30, 2004 compared to $0.49 and $0.48, respectively, for the same period last year. The increase in net income for both the three-month and six-month periods included a gain on sale of bank land totaling $482,000, which was recognized in the second quarter of 2004. TABLE 1 SUMMARY RESULTS OF OPERATIONS ($ in Thousands, except per share data)
Three months Three months Six months Six months ended ended ended ended June 30, 2004 June 30, 2003 June 30, 2004 June 30, 2003 ------------- ------------- ------------- ------------- Net income, as reported $ 2,593 $ 1,867 $ 4,489 $ 3,693 EPS-basic, as reported $ 0.34 $ 0.25 $ 0.59 $ 0.49 EPS-diluted, as reported $ 0.33 $ 0.24 $ 0.58 $ 0.48 Cash dividends declared $ 0.14 $ 0.13 $ 0.28 $ 0.26 Return on average assets, as reported 1.04% 0.83% 0.91% 0.82% Return on average equity, as reported 14.54% 11.14% 12.69% 11.18% Efficiency ratio, as reported (1) 57.64% 61.08% 60.23% 61.35%
(1) Noninterest expense divided by sum of taxable equivalent net interest income plus noninterest income, excluding investment securities gains, net The increase in net income for the three-month and six-month periods is primarily due to increased net interest income and a reduction in the provision for loan losses. This was offset partially by a decrease in other income and an increase in other expenses. Net Interest Income Net interest income is the largest component of the Company's operating income (net interest income plus other non-interest income) accounting for 76.3% of total operating income for the three months ended June 30, 2004, as compared to 72.4% for the same period in 2003. Net interest income represents the difference between interest earned on loans, investments and other interest earning assets offset by the interest expense attributable to the deposits and the borrowings that fund such assets. Interest fluctuations together with changes in the volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of earned interest income. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable. Net interest income on a tax equivalent basis for the three months ended June 30, 2004 increased $1.4 million, or 19.6%, to $8.6 million from $7.2 million over the comparable period a year ago. During the six months ended June 30, 2004, net interest income increased $2.4 million, or 16.6%, to $16.7 million from $14.3 million for the comparable period in 2003. 15 Net interest margin is tax-equivalent net interest income expressed as a percentage of average earning assets. The net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds to fund a portion of earning assets. As a result, the level of funds available without interest cost (demand deposits and equity capital) is an important component increasing net interest margin. The net interest margin for the second quarter of 2004 was 3.76%, up 30 basis points ("bps") from 3.46% for the comparable period in 2003. This comparable period increase was attributable to a 38 bps increase in interest rate spread (the net of a 77 bps reduction in the cost of interest-bearing liabilities offset partially by a 39 bps reduction in the yield on earning assets) and a 7 bps lower contribution from the net free funds. During the six months ended June 30, 2004, the net interest margin was 3.69% compared to 3.49% for the comparable period in 2003. Interest rates were relatively stable and historically low, with one interest rate decrease of 25 bps between the comparable three-months periods. The Federal funds rate was 1.00% throughout the second quarter of 2004 versus 1.25% throughout the same period in 2003. The Company had positioned the balance sheet to be slightly asset sensitive (which means that assets will re-price faster than liabilities); thus, the prolonged lower interest rate environment favorably lowered the cost of funding, but also lowered yields on earning assets, putting pressure on the net interest margin. In late June 2004, the Federal Reserve Board increased interest rates for the first time in several years. That increase was followed by a subsequent increase in August 2004. In gradually increasing interest rate environment, we would continue to anticipate that our balance sheet would benefit from asset sensitivity over the long term. For the three months ended June 30, 2004, average-earning assets increased $86.6 million, or 10.4%, when compared to the same period last year. The Company recorded an increase in average loans of $39.8 million, or 5.8%, for the second quarter of 2004 compared to the same period a year ago. For the six months ended June 30, 2004, average-earning assets increased $83.1 million, or 10.0%, when compared to the same period last year. The Company recorded an increase in average loans of $36.9 million, or 5.4%, for the six months ended June 30, 2004 compared to the same period a year earlier. Loans have typically resulted in higher rates of interest income to the Company than have investment securities. Interest rate spread is the difference between the tax-equivalent rate earned on average earning assets and the rate paid on average interest-bearing liabilities. The interest rate spread increased for the quarter ended June 30, 2004 when compared to the same period a year ago. The interest rate spread increased 38 bps to 3.57% at June 30, 2004 from 3.19% in the same quarter in 2003. While the average yield on earning assets decreased 39 bps during the period, the average rate paid on interest-bearing liabilities decreased 77 bps over the same period. For the six months ended June 30, 2004, the interest rate spread increased 26 bps to 3.50% from 3.24% for the same period a year earlier. The average yield on earning assets decreased 50 bps during the six-month period, while the average rate paid on interest-bearing liabilities decreased 76 bps. The reduction in the rates paid on interest-bearing liabilities occurred as a result of a lower cost of funding from deposits and other wholesale funding such as federal funds purchased and loans from the Federal Home Loan Bank. We would not expect that trend to continue in light of the recent Federal Reserve Board interest rate increases. 16 TABLE 2 NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS ($ In Thousands) Three months ended June 30,
2004 2003 Average Interest Average Average Interest Average Balance income/exp yield/rate Balance income/exp yield/rate ------------ ------------ ------------ ------------ ------------ ------------ ASSETS Earning assets: Loans, net (1)(2)(3) $ 723,250 $ 683,450 Less: non-accrual loans (10,528) (9,694) ------------ ------------ Loans, net 712,722 $ 10,070 5.68% 673,756 $ 10,194 6.07% Investments 208,615 2,441 4.71% 158,983 1,977 4.99% Other earning assets 54 0 0.00% 2,090 6 1.15% ------------ ------------ ------------ ------------ ------------ ------------ Total earning assets $ 921,391 $ 12,511 5.46% $ 834,829 $ 12,177 5.85% Allowance for loan losses (13,098) (12,610) Non-accrual loans 10,528 9,694 Cash and due from banks 17,954 16,054 Other assets 68,140 58,311 ------------ ------------ Total assets $ 1,004,915 $ 906,278 ------------ ------------ LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: NOW accounts $ 85,418 $ 177 0.83% $ 67,401 $ 176 1.05% Savings accounts 191,993 363 0.76% 190,904 461 0.97% Time deposits > $100M 213,490 1,251 2.36% 185,526 1,501 3.25% Time deposits < $100M 187,803 1,019 2.18% 217,349 1,839 3.39% ------------ ------------ ------------ ------------ ------------ ------------ Total interest-bearing deposits 678,704 2,810 1.67% 661,180 3,977 2.41% Short-term borrowings 31,514 107 1.37% 6,308 24 1.53% Customer repurchase agreements 1,100 3 1.10% 892 2 0.90% Other borrowings 97,888 544 2.24% 65,000 554 3.42% Long term debt 0 0 0.00% 53 0 0.00% Trust preferred securities 16,598 423 10.25% 16,100 411 10.24% ------------ ------------ ------------ ------------ ------------ ------------ Total interest-bearing liabilities $ 825,804 $ 3,887 1.89% $ 749,533 $ 4,968 2.66% ------------ ------------ ------------ ------------ ------------ ------------ Demand deposits 99,773 81,143 Accrued expenses and other liabilities 7,618 8,367 Stockholders' equity 71,720 67,235 ------------ ------------ Total liabilities and stockholders' equity $ 1,004,915 $ 906,278 ------------ ------------ Interest rate spread $ 8,624 3.57% $ 7,209 3.19% Contribution of free funds 0.20% 0.27% ------------ ------------ Net interest margin 3.76% 3.46% ------------ ------------
17 TABLE 3 NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS ($ In Thousands) Six months ended June 30,
2004 2003 Average Interest Average Average Interest Average Balance income/exp yield/rate Balance income/exp yield/rate ------------ ------------ ---------- ------------ ------------ ------------ ASSETS Earning assets: Loans, net (1)(2)(3) $ 715,467 $ 678,582 Less: non-accrual loans (10,974) (11,020) ------------ ------------ Loans, net 704,493 $ 19,802 5.65% 667,562 $ 20,390 6.16% Investments 206,732 4,853 4.72% 158,947 4,007 5.09% Other earning assets 55 0 0.00% 1,640 10 1.23% ------------ ------------ ---------- ------------ ------------ ------------ Total earning assets $ 911,280 $ 24,655 5.44% $ 828,149 $ 24,407 5.94% Allowance for loan losses (12,731) (12,226) Non-accrual loans 10,974 11,020 Cash and due from banks 17,478 17,641 Other assets 67,258 58,864 ------------ ------------ Total assets $ 994,259 $ 903,448 ------------ ------------ LIABILITIES AND STOCKHOLDER'S EQUITY Interest-bearing liabilities: NOW accounts $ 86,437 $ 352 0.82% $ 65,776 $ 340 1.04% Savings accounts 196,361 736 0.75% 193,693 982 1.02% Time deposits > $100M 203,390 2,522 2.49% 184,762 3,057 3.34% Time deposits < $100M 192,259 2,218 2.32% 216,950 3,694 3.43% ------------ ------------ ---------- ------------ ------------ ------------ Total interest-bearing deposits 678,447 5,828 1.73% 661,181 8,073 2.46% Short-term borrowings 32,343 217 1.35% 5,829 43 1.49% Customer repurchase agreements 1,062 5 0.95% 1,284 7 1.10% Other borrowings 90,336 1,023 2.28% 65,000 1,109 3.44% Long term debt 0 0 0.00% 53 1 3.80% Trust preferred securities 16,598 847 10.26% 16,100 822 10.30% ------------ ------------ ---------- ------------ ------------ ------------ Total interest-bearing liabilities $ 818,786 $ 7,920 1.95% $ 749,447 $ 10,055 2.71% ------------ ------------ ---------- ------------ ------------ ------------ Demand deposits 97,199 79,125 Accrued expenses and other liabilities 7,110 8,288 Stockholders' equity 71,164 66,588 ------------ ------------ Total liabilities and stockholders' equity $ 994,259 $ 903,448 ------------ ------------ Interest rate spread $ 16,735 3.50% $ 14,352 3.24% Contribution of free funds 0.19% 0.26% ---------- ------------ Net interest margin 3.69% 3.49% ---------- ------------
18 The ratio of average earning assets to average total assets measures management's ability to employ overall assets for the production of interest income. This ratio was 91.7% for the first six months of 2004 and 2003, respectively. Provision for Loan Losses The provision for loan losses ("PFLL") is the periodic cost (not less than quarterly) of providing an allowance for anticipated future loan losses. In any accounting period, the PFLL is based on the methodology used and management's evaluation of the loan portfolio, especially non-performing and other potential problem loans, taking into consideration many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's evaluation of loan quality, general economic factors and collateral values. The Company's loan review department performs a risk rating analysis as an integral part of the review of each loan portfolio. For the commercial and commercial real estate portfolios, the risk rating analysis includes a grading system following a standard risk-rating matrix. Based upon this matrix, the Company determines a risk rating assignment an appropriate measure to each loan examined. As a result, the Company has provided $1.5 million in PFLL for the first six months in 2004. The PFLL for the first half of 2004 at $1.5 million compares to a PFLL of $1.9 million for the first half in 2003. Net loan charge-offs in the first six months of 2004 were $578,000 compared with net charge-offs of $450,000 for the same period in 2003. Net charge-offs as a percentage of average loans is a key measure of asset quality. Net charge-offs to average loans were 0.16% for the first six months of 2004 compared to 0.13% for the same period in 2003. The increase in net charge-offs relates primarily to a $200,000 commercial loan charge-off stemming from a loan to a business services company. This loan had been previously been allocated a PFLL in the amount of 80% of the loan amount. During the period, non-accrual loans remained relatively stable, while restructured loans decreased significantly, primarily as a result of a $2.7 million credit that has improved in asset quality and transferred to a performing loan status. Management believes that the current provision conforms to the Company's loan loss reserve policy and is adequate in view of the present condition of the Company's loan portfolio. However, a decline in the quality of our loan portfolio, as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the allowance. If there are significant charge-offs against the allowance, or we otherwise determine that the allowance is inadequate, we will need to make higher provisions in the future. See "Risk Management and the Allowance for Loan Losses" below for more information related to non-performing loans. Non-Interest Income Total non-interest income decreased $69,000, or 2.5% to $2.7 million for the second quarter of 2004 when compared to the second quarter of 2003. For the six months ended June 30, 2004, total non-interest income 19 was $4.7 million, a decrease of $731,000, or 13.6%, compared to $5.4 million for the comparable period in 2003. The non-interest income to average assets ratio was 1.07% for the three months ended June 30, 2004 compared to 1.21% for the same period in 2003. For the six months ended June 30, 2004, the non-interest income to average assets ratio was 0.94% compared to 1.20% for the same period in 2003. The decrease in non-interest income for the three and six month periods is mainly due to decreases in loan servicing fee income and gains from sales of loans substantially offset by the gain recognized on the sale of bank land. TABLE 4 NONINTEREST INCOME ($ in Thousands)
Second Second Percent YTD YTD Percent Quarter 2004 Quarter 2003 change 2004 2003 change ------------ ------------ ------------ ------------ ------------ ------------ Trust 188 159 18.2% 362 293 23.5% Service charges on deposit accts 709 725 (2.2%) 1,364 1,431 (4.7%) Other fee income 155 152 2.0% 322 315 2.2% Loan servicing income 282 600 (53.0%) 620 1,062 (41.6%) Brokerage commissions 241 148 62.8% 389 228 70.6% Business owned life insurance 194 194 0.0% 392 336 16.7% Non-bank subsidiary income 0 0 NM 0 125 NM Gains from sales of loans 269 618 (56.5%) 482 1,043 (53.8%) Gain from sale of bank assets 482 0 NM 482 0 NM Gain from sale of non-bank subsidiary 0 0 NM 0 350 NM Other 155 148 4.7% 244 205 19.0% ------------ ------------ ------------ ------------ ------------ ------------ Total 2,675 2,744 (2.5%) 4,657 5,388 (13.6%)
In the second quarter and the first six months of 2004, loan servicing fees and gains from sales of loans were affected by a slowdown in refinancing activity throughout the industry due to higher mortgage rates. In comparison, those periods in 2003 saw high levels of loan refinancing as a result of the historically low interest rate environment. Loan servicing fees decreased $318,000 and gains from sales of loans decreased 20 $349,000 between the comparable quarters of 2004 and 2003. For the six months ended June 30, 2004, loan servicing fees decreased $442,000 and gains from sales of loans decreased $561,000 compared to the first six months of 2003. The decrease was driven primarily by secondary mortgage and commercial loan production (loan production to be sold to the secondary market) and resultant sales. As interest rates have increased over the quarter, the Company has seen a decrease in the number of loan applications. Secondary loan production declined 60.1% between the comparable first six-month periods ($31.7 million in the first half of 2004 versus $81.1 million in the first half of 2003). For both the three and six month periods, non-interest income included a gain recognized on the sale of bank land located in the Green Bay market area and totaled $482,000. The sale of property occurred as a result of a purchase of 19.2 acres by the Department of Transportation to facilitate its highway expansion efforts. We do not expect the sale to substantially affect operations at that location. Financial service income increased $161,000, or 70.6%, as a result of additional business generated and aided by stronger financial markets performance. Income from business owned life insurance ("BOLI") amounted to $392,000 for the first six months of 2004 compared to $336,000 a year earlier. A $13 million purchase of BOLI made in the second quarter of 2002 and an additional $4 million purchase made in the second quarter of 2003 impacted those results. Revenues generated from the operation of Arborview LLC ("Arborview") (a subsidiary formed in 2002 to manage a community based residential facility and sold in the first quarter of 2003) as a result of the sale were $0 and $125,000 for the first six months of 2004 and 2003, respectively. The subsidiary was sold in February 2003 with a gain on sale amounting to $350,000. Non-Interest Expense Non-interest expense increased $433,000, or 7.1%, to $6.5 million for the three months ended June 30, 2004 compared to the same period in 2003 as indicated in Table 4. For the six months ended June 30, 2004, total non-interest expense increased $773,000, or 6.4%, to $12.9 million compared to the same period in 2003. The non-interest expense to average assets ratio was 2.61% for the three months ended June 30, 2004 compared to 2.69% for the same period in 2003. For the six months ended June 30, 2004, non-interest expense ratio to average assets was 2.61% compared to 2.70% for the same period in 2003. Net overhead expense is total non-interest expense less total non-interest income excluding securities gains. The net overhead expenses to average assets ratio was 1.54% for the three months ended June 30, 2004 compared to 1.48% for the same period in 2003. For the six months ended June 30, 2004, the net overhead expenses to average assets ratio was 1.66% compared to 1.50% for the similar period in 2003. The efficiency ratio is total non-interest expense as a percentage of the sum of net-interest income on a fully taxable equivalent basis and total non-interest income. The efficiency ratio for the three months ended June 30, 2004 was 57.63% compared to 61.08% for the same period in 2003. For the six months ended June 30, 2004, the efficiency ratio was 60.23% compared to 61.35% for the same period in 2003. Efficiency ratio for the three and six month periods ended June 30, 2004 improved as a result of increased net interest income. Salaries and employee benefits showed an increase of $299,000, or 8.2%, to $3.9 million for the second quarter of 2004 compared to the same period in 2003. For the six months ended June 30, 2004, salary and employee benefits expenses increased $463,000, or 6.3%, to $7.8 million from $7.3 million for the comparable period in 2003. The number of full-time equivalent employees was 308 as of June 30, 2004 compared to 298 as of June 30, 2003. For the six months ended June 30, 2004, salary-related expenses increased $284,000, or 5.5%, due principally to merit increases between the years. Benefit costs, principally for health insurance and pension costs, represent the remaining increase in personnel-related costs. The increase in health insurance costs is expected to continue for the balance of 2004. Management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to continue in future years. 21 TABLE 5 NONINTEREST EXPENSE ($ in Thousands)
Second Second Percent YTD YTD Percent quarter 2004 quarter 2003 change 2004 2003 change ------------ ------------ ------------ ------------ ------------ ------------ Personnel 3,944 3,645 8.2% 7,809 7,346 6.3% Occupancy 529 478 10.7% 1,051 947 11.0% Equipment 299 423 (29.3%) 668 816 (18.1%) Data processing 272 266 2.3% 555 538 3.2% Business development/advertising 267 191 39.8% 394 308 27.9% Supplies and printing 132 138 (4.3%) 241 241 0.0% Director fees 112 106 5.7% 210 200 5.0% FDIC 28 30 (6.7%) 57 59 (3.4%) Amortization of MSR's 66 95 (30.5%) 132 185 (28.6%) Legal and professional 102 122 (16.4%) 194 223 (13.0%) Operation of other real estate 146 34 329.4% 271 137 97.8% Other 615 551 11.6% 1,302 1,111 17.2% ------------ ------------ ------------ ------------ ------------ ------------ Total 6,512 6,079 7.1% 12,884 12,111 6.4%
Expenses related to the operation of other real estate owned increased $112,000 to $146,000 for the quarter ended June 30, 2004 compared to the same period in 2003. For the six-month period ended June 30, 2004, other real estate owned expenses increased $134,000 to $271,000 compared to the same period in 2003. Included in these expenses were net gains taken on the sale of other real estate owned amounting to $64,000 for the first six months of 2004 compared to net gains taken on sale of $11,000 for the same period in 2003. In addition, costs related to the holding of other real estate owned properties increased $257,000 to $405,000 for the first quarter of 2004. Income Taxes Income tax expense for the Company for the six months ended June 30, 2004 was $2.0 million, an increase of $599,000, or 43.9%, compared to the same period in 2003. The higher tax expense in 2004 reflected the Company's increase in before tax earnings offset partially by a decrease in tax-exempt interest income. The Company's effective tax rate (income tax expense divided by income before taxes) was 30.5% for the six months ended June 30, 2004 compared with 27.0% for the same period in 2003. The effective tax rate of 30.5% consisted of a federal effective tax rate of 25.9% and Wisconsin State effective tax rate of 4.6%. Income tax expense recorded in the consolidated statements of income involves the interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Company undergoes examination by varying taxing authorities. Such taxing authorities may require that changes in the amount of income tax or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. The Company has not provided any specific reserves relative to any positions recently taken by State taxing authorities. See section titled "Critical Accounting Policies." 22 Income tax expense may be affected by developments in the state of Wisconsin. Like many financial institutions that are located in Wisconsin, a subsidiary of the Bank located in the state of Nevada holds and manages various investment securities. Due to that fact that these subsidiaries are out of state, income from their operations has not been subject to Wisconsin state taxation. Although the Wisconsin Department of Revenue issued favorable tax rulings regarding Nevada subsidiaries of Wisconsin financial institutions, the Department representatives have recently stated that the Department intends to revoke those rulings and tax some or all these subsidiaries' income, even though there has been no intervening change in the law. The Department has also implemented a program for the audit of Wisconsin financial institutions who have formed and contributed assets to subsidiaries located in Nevada. The Department sent letters in late July 2004 to financial institutions in Wisconsin, whether or not they are undergoing an audit, reporting on settlements involving 17 banks and their out-of-state investment subsidiaries. The letter provided a summary of currently available settlement parameters. For periods before 2004, they include: restrictions on the types of subsidiary income excluded from Wisconsin taxation; assessment of certain back taxes for a limited period of time; and interest (but not penalties) on any past-due taxes. Going forward, including 2004, there are similar provisions plus limits on the amount of subsidiaries' assets as to which their income will be excluded from Wisconsin tax. Settlement on the terms outlined would result in the Department's rescission of related prior letter rulings, and would purport to be binding going forward except for future legislation or change by mutual agreement. By implication, the Department appears to accept the general proposition that some out-of-state investment subsidiary income is not subject to Wisconsin taxes. At this time, the Department has not audited or made an assessment against the Company's subsidiaries nor has the Company determined how it intends to respond. The letter did not provide sufficient detail to permit the Company to assess what effects the acceptance of such a settlement offer might have upon it, and the Company does not have sufficient information to determine what the Department's position would be if an assessment were made and the Bank were to challenge it. The Company intends to seek that information from the Department and to evaluate the impact of such a settlement after receiving more specific detail. The Bank's net income would be reduced if there would be an assessment against it or it determined to settle. The Bank could also incur costs in the future to address any action taken against it by the Department. Balance Sheet Analysis Loans At June 30, 2004, total loans increased $28.6 million, or 4.1%, to $724.6 million from $696.0 million at December 31, 2003. Growth in the Company's loan portfolio resulted primarily from an increase in real estate commercial loans to $411.0 million at June 30, 2004 compared to $387.8 million at December 31, 2003. Growth in commercial real estate mortgages and commercial loans occurred principally as a result of the Company's expansion efforts (primarily in the Green Bay market) and the strong economic growth existing in that market. The following table reflects the composition (mix) of the loan portfolio (dollars in thousands): 23 TABLE 6 LOAN PORTFOLIO ANALYSIS ($ in Thousands)
June 30, December 31, Percent 2004 2003 change ------------- ------------- ------------- Amount of loans by type (dollars in thousands) Real estate-mortgage Commercial $ 410,953 $ 387,820 5.96% 1-4 family residential First liens 76,151 72,494 5.04% Junior liens 19,605 21,443 (8.57%) Home equity 34,060 31,763 7.23% Commercial, financial and agricultural 89,718 91,009 (1.42%) Real estate-construction 81,022 77,350 4.75% Installment Credit cards and related plans 1,987 2,145 (7.37%) Other 11,662 12,315 (5.30%) Less: deferred origination fees, net of costs 545 349 56.16% ------------- ------------- ------------- Total $ 724,613 $ 695,990 4.11%
Risk Management and the Allowance for Loan Losses The loan portfolio is the Company's primary asset subject to credit risk. To reflect this credit risk, the Company sets aside an allowance or reserve for credit losses through periodic charges to earnings. These charges are shown in the Company's consolidated income statement as provision for loan losses. See "Provision for Loan Losses" above. Credit risk is managed and monitored through the use of lending standards, a thorough review of potential borrowers, and an on-going review of payment performance. Asset quality administration, including early identification of problem loans and timely resolution of problems, further enhances management of credit risk and minimization of loan losses. All specifically identifiable and quantifiable losses are immediately charged off against the allowance. Charged-off loans are subject to periodic review, and specific efforts are taken to achieve maximum recovery of principal and interest. As the following table indicates, the ALL at June 30, 2004 was $13.1 million compared with $12.2 million at the end of 2003. Loans increased 4.1% from December 31, 2003 to June 30, 2004, while the allowance as a percent of total loans increased due to the loan loss provision being higher in comparison to loan growth for the first six months of 2004. Based on management's analysis of the loan portfolio risk at June 30, 2004, a provision expense of $1.5 million was recorded for the six months ended June 30, 2004, a decrease of $426,000 or 22.1% compared to the same period in 2003. Commercial loans represented 73.5% of the net charge-offs for the first six months of 2004. 24 TABLE 7 ALLOWANCE FOR LOAN LOSSES AND NONPERFORMING ASSETS ($ in thousands)
At or for the At or for the At or for the ended period ended period ended period June 30, 2004 June 30, 2003 December 31, 2003 ------------- ------------- ----------------- Allowance for Loan Losses ("ALL") Balance at beginning of period $ 12,159 $ 11,410 $ 11,410 Provision for loan losses 1,499 1,925 5,650 Charge-offs 1,129 856 6,345 Recoveries 551 406 1,444 ------------- ------------- ------------- Balance at end of period 13,080 12,885 12,159 Net charge-offs ("NCOs") 578 450 4,901 Nonperforming Assets: Nonaccrual loans $ 11,104 $ 10,987 $ 11,079 Accruing loans past due 90 days or more 0 0 0 Restructured loans 2,254 8,528 5,144 ------------- ------------- ------------- Total nonperforming loans $ 13,358 $ 19,515 $ 16,223 ("NPLs") Other real estate owned 2,614 668 2,271 ------------- ------------- ------------- Total nonperforming assets ("NPAs") $ 15,972 $ 20,183 $ 18,494 Ratios: ALL to NCO's (annualized) 11.25 14.20 2.48 NCO's to average loans (annualized) 0.16% 0.13% 0.72% ALL to total loans 1.81% 1.90% 1.75% NPL's to total loans 1.84% 2.88% 2.33% NPA's to total assets 1.59% 2.22% 1.90% ALL to NPL's 97.92% 66.03% 74.95%
While management uses available information to recognize losses on loans, future adjustments to the ALL may be necessary based on changes in economic conditions and the impact of such change on the Company's borrowers. Table 8 shows the amount of the ALL allocated for the time periods indicated to each loan type as described. It also shows the percentage of balances for each loan type to total loans. Management continues to target and maintain the ALL equal to the allocation methodology plus an unallocated portion, as determined by economic conditions on the Company's borrowers. In general, it would be expected that those types of loans which have historically more loss associated with them, will have a proportionally larger amount of the allowance allocated to them than do loans which have less risk. Consideration for making such allocations is consistent with the factors discussed above, and all of the factors are subject to change; thus, the allocation is not necessarily indicative of the loan categories in which future loan losses will occur. It would also be expected that the amount allocated for any particular type of loan will increase or decrease proportionately to both the changes in the loan balances and to increases or decreases in the estimated loss in loans of that type. In other words, changes in the risk profile of the various parts of the loan portfolio should be reflected in the allowance allocated. 25 TABLE 8 ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES ($ in thousands)
June 30, 2004 June 30, 2003 Dec 31, 2003 Percent of Percent of Percent of loans to loans to loans to Amount total loans Amount total loans Amount total loans ----------- ----------- ----------- ----------- ----------- ----------- Commercial, financial & agricultural $ 3,338 12.38% $ 4,122 13.34% $ 2,386 13.08% ----------- ----------- ----------- ----------- ----------- ----------- Commercial real estate 6,545 56.64% 5,480 55.29% 6,772 55.67% Real Estate: Construction 1,069 11.18% 800 9.74% 702 11.11% Residential 945 13.22% 1,450 15.30% 1,246 13.50% Home equity lines 85 4.70% 225 4.12% 79 4.56% Consumer 229 1.61% 160 1.90% 235 1.77% Credit card 71 0.27% 69 0.31% 111 0.31% Loan commitments 492 279 276 Not specifically allocated 306 300 352 ----------- ----------- ----------- Total allowance $ 13,080 100.00% $ 12,885 100.00% $ 12,159 100.00% Allowance for credit loss as a percentage of total loans 1.81% 1.90% 1.75% Period end loans $ 724,613 $ 678,036 $ 695,990
While there exists probable asset quality problems in the loan portfolio, management believes sufficient reserves have been provided in the ALL to absorb probable losses in the loan portfolio at June 30, 2004. Ongoing efforts are being made to collect these loans, and the Company involves the legal process when necessary to minimize the risk of further deterioration of these loans for full collection. While management uses available information to recognize losses on loans, future adjustments to the ALL may be necessary based on changes in economic conditions and the impact of such change on the Company's borrowers. As an integral part of their examination process, various regulatory agencies also review the Company's ALL. Such agencies may require that changes in the ALL be recognized when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. Non-Performing Loans, Potential Problem Loans and Other Real Estate Management encourages early identification of non-accrual and problem loans in order to minimize the risk of loss. This is accomplished by monitoring and reviewing credit policies and procedures on a regular basis. Non-performing loans remain a leading indicator of future loan loss potential. Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days or more past due but still accruing, and restructured loans. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collection of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income. Restructuring loans involve the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes. As indicated in Table 7, non-performing loans at June 30, 2004 were $13.4 million compared to $16.2 million at December 31, 2003. Impacting the decrease in non-performing loans was a shift, as a result of foreclosure, of approximately $1.4 million in loans to other real estate owned during 2004. Non-accrual loans represented $11.1 million of the total non-performing loans. Real estate non-accrual loans accounted for $10.0 million of the total, of which $1.8 million was residential real estate and $8.0 million was commercial real estate, while commercial and industrial non-accrual loans total $1.0 million. Management believes collateral is sufficient to offset losses in the event additional legal action would be warranted to collect these non-accrual loans. Restructured loans were $2.3 million at June 30, 2004 compared with $5.1 million at year-end 2003. Of the restructured loans at June 30, 2004, approximately $1.6 million consisted of one commercial credit and conditional loan as to which the Bank has granted various concessions as a result of the borrowers' past cash flow problems. This loan credit was 61 days past due at June 30, 2004. Management has allocated a loan loss provision of $1.3 million. This allocation relates to the commercial 26 credit of $1.6 million, which is the net amount remaining after a loan charge-off of $2.6 million in 2003. As a result of the cash flow problems of the debtor, management is continuing to specially monitor this loan on a monthly basis and is working with the borrower to minimize any additional loss exposure. If the loan becomes past due greater than 89 days, this loan may be subject to further charge-off. As a result the ratio of non-performing loans to total loans at June 30, 2004 was 1.84% compared to 2.33% at end of year 2003. The Company's ALL was 97.9% of total non-performing loans at June 30, 2004 compared to 75.0% at end of year 2003. As indicated in Table 7, non-performing assets (non-performing loans plus other real estate owned assets) at June 30, 2004 were $16.0 million compared to $18.5 million at December 31, 2003. Other real estate owned, which represents property that the Company acquired through foreclosure or in satisfaction of debt, consisted of ten residential and thirteen commercial properties totaling $2.6 million. Other real estate owned at December 31, 2003 totaled $2.3 million and consisted of nineteen properties. Potential problem loans are currently performing loans that management believes may incur difficulties in complying with loan repayment terms. Management's decision to place loans in this category does not necessarily mean that the Company expects to take losses on such loans, but that management needs to be more vigilant in its efforts to oversee the loans and recognize that a higher degree of risk is associated with these potential problem loans. At June 30, 2004, potential problem loans amounted to $4.2 million compared to a total of $5.7 million at December 31, 2003. Of the potential problem loans, $3.9 million of the problem loans stems from one commercial credit experiencing cash flow concerns. Various commercial loans totaling $300,000 make up the balance of the total potential problem loans. With the exceptions of the $3.9 million commercial credit noted above, potential problem loans are not concentrated in a particular industry but rather cover a diverse range of businesses. Except as noted above, management does not presently expect significant losses from credits in the potential problem loan category. Investment Portfolio The investment portfolio is intended to provide the Company with adequate liquidity, flexibility in asset/liability management and, lastly, its earning potential. At June 30, 2004, the investment portfolio (which includes investment securities available for sale and held to maturity) increased $3.6 million, or 1.8%, to $199.4 million from $195.8 million at December 31, 2003. At June 30, 2004, the investment portfolio represented 19.8% of total assets compared with 20.1% at December 31, 2003. Securities held to maturity and securities available for sale consist of the following: TABLE 9 INVESTMENT SECURITY ANALYSIS At June 30, 2004 ($ in Thousands)
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------ ------------ ------------ ------------ Securities held to maturity Obligations of states & political subdivisions $ 17,284 $ 94 $ 0 $ 17,378 ------------ ------------ ------------ ------------ Securities available for sale Obligations of U.S. Treasury & 47,360 994 495 47,859 other U.S. agencies Mortgage-backed securities 101,342 78 2,368 99,052 Obligations of states & political subdivisions 30,309 1,300 7 31,602 Other securities 3,559 78 0 3,637 ------------ ------------ ------------ ------------ Total securities available for sale $ 182,570 $ 2,450 $ 2,870 $ 182,150
27 At December 31, 2003 ($ in Thousands)
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------ ------------ ------------ ------------ Securities held to maturity Obligations of states & political subdivisions $ 19,032 $ 282 $ 0 $ 19,314 ------------ ------------ ------------ ------------ Securities available for sale Obligations of U.S. Treasury & $ 37,942 $ 1,760 $ 6 $ 39,696 other U.S. Agencies Mortgage-backed securities 99,970 204 1,026 99,148 Obligations of states & 32,848 2,167 0 35,015 political subdivisions Other securities 2,877 79 0 2,956 ------------ ------------ ------------ ------------ Total securities available for sale $ 173,637 $ 4,210 $ 1,032 $ 176,815
At June 30, 2004, the contractual maturities of securities held to maturity and securities available for sale are as follows: TABLE 10 INVESTMENT PORTFOLIO MATURITY ($ in Thousands)
Securities held to Maturity Securities Available for Sale Amortized Cost Market Value Amortized Cost Market Value -------------- ------------- -------------- ------------- Within 1 year $ 3,668 $ 3,678 $ 2,876 $ 2,953 After 1 but within 5 years 6,783 6,865 128,829 128,186 After 5 but within 10 years 2,443 2,445 36,337 36,176 After 10 years 4,390 4,390 10,969 11,198 Equity securities 0 0 3,559 3,637 ------------- ------------- ------------- ------------- Total $ 17,284 $ 17,378 $ 182,570 $ 182,150
28 Deposits Total deposits at June 30, 2004 decreased $3.7 million, or 0.5%, to $780.0 million from $783.3 million at December 31, 2003. Non-interest bearing deposits at June 30, 2004 decreased $1.4 million, or 1.3%, to $105.3 million from $106.6 million at December 31, 2003. Interest-bearing deposits at June 30, 2004 decreased $2.3 million, or 0.3%, to $674.4 million from $676.7 million at December 31, 2003. Interest-bearing transaction accounts (NOW deposits) decreased $2.1 million, primarily in public fund deposits. Savings deposits decreased $11.8 million, or 5.8%, to $192.5 million at June 30, 2004, when compared to $204.3 million at December 31, 2003. Time deposits (including time, $100,000 and over and other time) increased $11.6 million (includes increase of $25.0 million in time deposits over $100,000), or 3.1%, to $391.7 million at June 30, 2004, when compared to $380.1 million at December 31, 2003. Brokered CD's totaled $126.6 million at June 30, 2004 compared to $97.8 million at December 31, 2003. Time deposits greater than $100,000 and brokered time deposits were priced within the framework of the Company's rate structure and did not materially increase the average rates on deposit liabilities. Although the use of brokered deposits has increased, Management views these as a stable source of funds, although they are inherently less stable than locally-generated deposits. If liquidity concerns arose, the Company has alternative sources of funds such as lines with correspondent banks and borrowing arrangements with FHLB should the need present itself. Increased competition for consumer deposits and customer awareness of interest rates continues to limit the Company's core deposit growth in these types of deposits. Typically, overall deposits for the first six months tend to decline slightly as a result of the seasonality of the Company's customer base as customers draw down deposits during the early first half of the year in anticipation of the summer tourist season. Emphasis has been, and will continue to be, placed on generating additional core deposits in 2004 through competitive pricing of deposit products and through the branch delivery systems that have already been established. The Company will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. The Company also may increase brokered time deposits during the remainder of the year 2004 as an additional source of funds to provide for loan growth in the event that core deposit growth goals would not be accomplished. Under that scenario, the Company will continue to look at other wholesale sources of funds, if the brokered CD market became illiquid or more costly in terms of interest rate. Short Term Borrowings and Other Borrowings Short-term borrowings at June 30, 2004 consist of federal funds purchased and securities under agreements to repurchase. Total short-term borrowings at June 30, 2004 increased $10.2 million to $33.6 million from $23.4 million at December 31, 2003. Federal funds purchased increased from $23.3 million at December 31, 2003 to $32.3 million at June 30, 2004 accounting for the balance of the increase in the balance of short-term borrowings. These have increased as a result of growth in the loan portfolio coupled with a decrease in core deposits during the quarter ended June 30, 2004. Other borrowings consist of term loans with FHLB. These borrowings totaled $100.2 million at June 30, 2004 compared to $75.1 million at December 31, 2003. Typically, short-term borrowings and other borrowings increase in order to fund growth in the loan portfolio. The Company will borrow monies if borrowing is a less costly form of funding loans compared to the cost of acquiring deposits or if deposit growth is not sufficient. Additionally, the availability of deposits also determines the amount of funds the Company needs to borrow in order to fund loan demand. In the quarter ended June 30, 2004, borrowings were also required in view of the decrease in deposits. The Company anticipates it will continue to use wholesale funding sources of this nature, if these borrowings add incrementally to overall profitability. 29 Long Term Debt In connection with the issuance of Trust Preferred Securities in 2001 (see "Capital Resources"), the Company issued long-term subordinated debentures to Baylake Capital Trust I, a Delaware Business Trust subsidiary of the Company. The aggregate principal amount of the debentures due 2031, to the trust subsidiary is $16,597,940. For additional details, please make reference to the Consolidated Financial Statements and the accompanying footnotes on the Company's Form 10-K for the year 2003. Contractual Obligations, Commitments, Off-Balance Sheet Risk, and Contingent Liabilities The Company utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2003 for discussion with respect to the Company's quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in Form 10-K have not materially changed since that report was filed. The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments, at June 30: TABLE 11 LENDING RELATED COMMITMENTS ($ in Thousands)
June 30, 2004 June 30, 2003 ------------- ------------- Commitments to fund home equity line loans $ 27,977 $ 39,229 Commitments to fund commercial real estate loans 3,790 2,105 Commitments unused on various other lines of credit loans 139,617 103,419 ------------- ------------- Total commitments to extend credit $ 171,384 $ 144,753 Financial standby letters of credit $ 21,862 $ 17,985
Liquidity Liquidity management refers to the ability of the Company to ensure that cash is available in at timely manner to meet loan demand and depositors' needs, and to service other liabilities as they become due, without undue cost or risk, and without causing a disruption to normal operating activities. The Company and the Bank have different liquidity considerations. The Company's primary sources of funds are dividends from the Bank, investment income, and net proceeds from borrowings and the offerings of junior subordinated obligations, in addition to the issuance of its common stock securities. The Company manages its liquidity position in order to provide funds necessary to pay dividends to its shareholders. Dividends received from Bank totaled $2.2 million for the first six months of 2004 and will continue to be the Company's main source of long-term liquidity. The dividends from the Bank along with existing cash were sufficient to pay cash dividends to the Company's shareholders of $3.2 million in the first six months of 2004. The Bank meets its cash flow needs by having funding sources available to it to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity at the Bank is derived from deposit growth, maturing loans, the maturity of the investment portfolio, access to other funding sources, marketability of certain of its assets; the ability to use its loan and investment portfolios as collateral for secured borrowings and strong capital positions. 30 Maturing investments have been a primary source of liquidity at the Bank. For the six months ended June 30, 2004, principal payments totaling $17.0 million were received on investments. $24.7 million in investments were purchased in the first six months of 2004. This resulted in net cash of $7.7 million used in investing activities for the first six months of 2004. At June 30, 2004, the carrying or book value of investment securities maturing within one year amounted to $7.7 million or 3.8% of the total investment securities portfolio. This compares to 6.1% level for investment securities with one year or less maturities as of December 31, 2003. Within the investing activities of the statement of cash flows, sales and maturities of investment securities during the first six months of 2004 totaled $17.0 million. At June 30, 2004, the investment portfolio contained $146.9 million of U.S. Treasury and federal agency backed securities representing 73.7% of the total investment portfolio. These securities tend to be highly marketable and had a market value below amortized cost at June 30, 2004 amounting to $1.8 million. Deposit growth is typically another source of liquidity for the Bank. As a financing activity reflected in the June 30, 2004 Consolidated Statements of Cash Flows, deposits decreased and resulted in $3.7 million of cash outflow during the first six months of 2004. The Company's overall deposit base decreased 0.5% for the six months ended June 30, 2004. Deposit growth is the most stable source of liquidity for the Bank, although brokered deposits are inherently less stable than locally generated core deposits. Affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause the Bank to develop alternative sources of funds which may not be as liquid and potentially a more costly alternative. The scheduled maturity of loans can provide a source of additional liquidity. The Bank has $226.3 million, or 31.2%, of loans maturing within one year. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing loans. The Bank's liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand as a need for liquidity will cause the Company to acquire other sources of funding which could be harder to find; therefore more costly to acquire. Within the classification of short-term borrowings and other borrowings at June 30, 2004, federal funds purchased and securities sold under agreements to repurchase totaled $33.6 million compared to $23.4 million at the end of 2003. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Borrowings from FHLB, short-term or term, are another source of funds. They total $100.2 million at June 30, 2004 and $75.1 million at December 31, 2003. The Bank's liquidity resources were sufficient in the first six months of 2004 to fund the growth in loans and investments, increase the volume of interest earning assets and meet other cash needs when necessary. Management expects that deposit growth will continue to be the primary funding source of the Bank's liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities, and a strong capital position. Although federal funds purchased and borrowings from the FHLB provided funds in the first six months of 2004, management expects deposit growth to be a reliable funding source in the future as a result of branch expansion efforts and marketing efforts to attract and retain core deposits. In addition, Bank may acquire additional brokered deposits as funding for short-term liquidity needs. Shorter-term liquidity needs will mainly be derived from growth in short-term borrowings, maturing federal funds sold and portfolio investments, loan maturities and access to other funding sources. In assessing liquidity, historical information such as seasonality (loan demand's affect on liquidity which starts before and during the tourist season and deposit draw down which affects liquidity shortly before and during the early part of the tourist season), local economic cycles and the economy in general are considered along with the current ratios, management goals and the unique characteristics of the Company. Management believes that, in the current economic environment, the Company's and the Bank's liquidity position is adequate. To management's knowledge, there are no known trends nor any known demands, 31 commitments, events or uncertainties that will result or are reasonably likely to result in a material increase or decrease in the Bank's or the Company's liquidity. Capital Resources Stockholders' equity at June 30, 2004 increased $627,000 or 0.9% to $70.3 million, compared with $69.6 million at end of year 2003. The increase in stockholders' equity in 2004 was primarily composed of the retention of earnings and the exercise of stock options with offsetting decreases to stockholders' equity from the payment of dividends and the change in unrealized losses on available for sale securities. Stockholders' equity to assets at June 30, 2004 was 6.98% compared to 7.14% at the end of 2003. In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory business trust organized for the sole purpose of issuing trust preferred securities and investing the proceeds thereof in junior subordinated debentures of the Company, the sole asset of the Trust. The trust preferred securities enhanced regulatory capital and added liquidity. The common securities of the Trust are wholly-owned by the Company. The trust preferred securities and common securities of the trust represent preferred undivided beneficial interests in the assets of Baylake Capital Trust I, and the holder of the preferred securities will be entitled to a preference over the common securities of the Trust upon an event of default with respect to distributions and amounts payable on redemption or liquidation. These trust preferred securities are tax-advantaged issues for the Company that qualify for Tier 1 capital treatment to the Company. Distributions on these securities are included in interest expense on guaranteed preferred beneficial interest. The preferred securities are traded on the American Stock Exchange under the symbol BYL_p. As of December 31, 2003, the Company deconsolidated the Trust, which had issued the trust preferred securities (discussed above), and replaced the presentation of such instruments with the Company's junior subordinated debentures issued to the Trust. Such presentation reflects adoption of FASB Interpretation No. 46 (FIN 46 R) issued in December 2003. The Company had $16.6 million of junior subordinated debentures outstanding to the Trust and the Trust had $16.1 million of trust preferred securities outstanding at June 30, 2004 and December 31, 2003, respectively. Under applicable regulatory guidelines, the 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. As of June 30, 2004, all $16.1 million of the Trust Preferred Securities qualify as Tier 1 Capital. The Company's capital base (before SFAS 115 change) increased primarily due to the retention of earnings. The Company's dividend reinvestment plan typically provides capital improvement, as the holders of approximately 23% of Company's Common Stock participate in the plan. Cash dividends paid in the first six months of 2004 were $0.28 per share compared with $0.26 in 2003. The Company provided a 7.7% increase in normal dividends per share in 2004 over 2003 as a result of earnings for 2004. Total funds utilized in the payment of dividends was $3.2 million in the first six months of 2004, as compared to $2.9 million in the corresponding period of 2003. In 1997, the Company's Board of Directors authorized management, in its discretion, to repurchase up to 7,000 shares of the Company's common stock each calendar quarter in the market. The shares repurchased would be used to fill its needs for the dividend reinvestment program, any future benefit plans, and the Company's stock purchase plan. Shares repurchased are held as treasury stock and accordingly, are accounted for as a reduction of stockholders' equity. The Company repurchased none of its common shares in the first six months of 2004. The adequacy of the Company's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. 32 Management is confident that because of current capital levels and projected earnings levels, capital levels are more than adequate to meet the ongoing and future concerns of the Company. The Federal Reserve Board has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory -and possible additional discretionary- actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements. At June 30, 2004 and December 31, 2003, the Company was categorized as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. To be "well capitalized" under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%. The following table presents the Company's and the Bank's capital ratios as of June 30, 2004 and December 31, 2003: TABLE 12 CAPITAL RATIOS ($ in Thousands)
To Be Well For Capitalized under Capital Adequacy Prompt Corrective Actual Purposes Action Provisions --------------------------- --------------------------- --------------------------- ($ in Thousands) Amount Ratio Amount Ratio Amount Ratio ----------- ----------- ----------- ----------- ----------- ----------- As of June 30, 2004 Total Capital (to Risk Weighted Assets) Company 92,250 10.94% 67,430 8.00% 84,287 10.00% Bank 87,912 10.45% 67,280 8.00% 84,100 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 81,683 9.69% 33,715 4.00% 50,572 6.00% Bank 77,638 9.20% 33,640 4.00% 50,460 6.00% Tier 1 Capital (to Average Assets) Company 81,683 8.20% 39,860 4.00% N/A N/A Bank 77,368 7.76% 39,860 4.00% 49,824 5.00% As of December 31, 2003 Total Capital (to Risk Weighted Assets) Company 88,493 10.78% 65,650 8.00% 82,090 10.00% Bank 84,771 10.33% 65,647 8.00% 82,059 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 78,212 9.52% 32,845 4.00% 49,293 6.00% Bank 74,493 9.08% 32,823 4.00% 49,235 6.00% Tier 1 Capital (to Average Assets) Company 78,212 8.38% 37,331 4.00% N/A N/A Bank 74,493 7.98% 37,331 4.00% 46,664 5.00%
33 Management believes that a strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share, and to provide depositor and investor confidence. The Company's capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. Management actively reviews capital strategies for the Company to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements. Recent Accounting Pronouncements In January 2003, the FASB issued FASB Interpretations No. 46 ("FIN 46"), Consolidation of Variable Interest Entities." The objective of this interpretation is to provide guidance on how to identify a variable interest entity ("VIE") and determine when the assets, liabilities, non-controlling interests and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the entity's expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. FIN 46 was effective for all VIE's created after January 31, 2003. However, the FASB had postponed that effective date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46 (FIN 46 R), which further delayed this effective date until March 31, 2004 for VIE's created prior to February 1, 2003, except for special purpose entities, which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The requirements of FIN 46 resulted in the deconsolidation of the Company's wholly owned subsidiary trusts, formed to issue mandatorily redeemable preferred securities ("trust preferred securities"). The deconsolidation, as of December 31, 2003, results in the recognition of the trust preferred securities as junior subordinated obligations on the related consolidated statement of financial condition. The junior subordinated obligations of the trusts also include common interests, which aggregate $497,940, and are offset by an identical amount representing the Company's investment and included in other assets. The provisions of FIN 46 R had no impact on the Company's consolidated statements of income or cash flows. On March 9, 2004, the SEC issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments." According to the release, the fair value of the loan commitment is determined without considering the value of future cash flows related to servicing the loan, and thus the fair value represents the value of having to make a loan at what may become a below-market rate. This guidance is applicable for mortgage loan commitments accounted for as derivatives and entered into subsequent to March 31, 2004. In management's opinion, the adoption of Staff Accounting Bulletin No. 105 will not have a material effect on the Company's consolidated financial statements. Item 3. Quantitative and Qualitative Disclosure about Market Risk. The Company's financial performance is affected by, among other factors, credit risk and interest rate risk. The Company does not use derivatives to mitigate its interest rate risk or credit risk, relying instead on loan review and its loan loss reserve. The Company's earnings are derived from the operations of its direct and indirect subsidiaries with particular reliance on net interest income, calculated as the difference between interest earned on loans and investments and the interest expense paid on deposits and other interest bearing liabilities, including advances from FHLB and other borrowings. Like other financial institutions, the Company's interest income and interest expense are affected by general economic conditions and by the policies of regulatory 34 authorities, including the monetary policies of the Board of Governors of the Federal Reserve System. Changes in the economic environment may influence, among other matters, the growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing. Fluctuations in interest rates are not predictable or controllable. As of June 30, 2004, the Company was in compliance with its management policies with respect to interest rate risk. The Company has not experienced any material changes to its market risk position since December 31, 2003, as described in the Company's 2003 Form 10-K Annual Report. The Company's overall interest rate sensitivity is demonstrated by net interest income analysis. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% to 2.0% increases and decreases in market interest rates. The table below presents the Company's projected changes in net interest income for the various rate shock levels at June 30, 2004.
Change in Net Interest Income over One Year Horizon -------------------------------------------------------- At June 30, 2004 At December 31, 2003 ------------------------ ------------------------- Change in levels of Dollar Percentage Dollar Percentage interest rates change change change change - -------------- ------- ---------- ------- ---------- +200 bp 2,643 7.31% 1,773 4.90% +100 bp 1,350 3.74% 1,049 2.90% Base 0 0% 0 0% - -100 bp (1,089) (3.01%) (1,266) (3.50%)
As shown above, at June 30, 2004, the effect of an immediate 200 basis point increase in interest rates would increase the Company 's net interest income by $2.6 million or 7.3%. The effect of an immediate 100 basis point reduction in rates would decrease the Company's net interest income by $1.1 million or 3.0% Changes in the mix of earning assets and interest-bearing liabilities increased the Company's asset sensitivity during the past twelve months. Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. Item 4. Controls and Procedures DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of June 30, 2004. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company's disclosure controls and procedures to the Company required to be included in this quarterly report on Form 10-Q. INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal controls subsequent to the date of such evaluation. 35 Part II - Other Information Item 1. Legal Proceedings Baylake and its subsidiaries may be involved from time to time in various routine legal proceedings incidental to its business. Neither Baylake nor any of its subsidiaries is currently engaged in any legal proceedings that are expected to have a material adverse effect on the results of operations or financial position of Baylake. Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders a) The Company's Annual Meeting of Shareholders was held on June 7, 2004. b) Not applicable c) The only matter voted upon was the election of four directors for terms expiring in 2007. The results are as follows:
Election of directors For Against or withheld - ---------------------------------------- --------- ------------------- John W. Bunda 5,837,997 637,259 Roger G. Ferris 6,243,527 231,729 Thomas L. Herlache 6,234,928 240,328 Paul Jay Sturm 6,240,766 234,490
As a consequence of the Company's staggered board of directors, other directors remained in office. Directors continuing in office for terms expiring in 2005 are Robert W. Agnew, George Delveaux, Jr., Dee Geurts-Bengtson, and Joseph Morgan. Directors continuing in office for terms expiring in 2006 are Ronald D. Berg, Richard A. Braun and William C. Parsons. Item 5. Other Information None 36 Item 6. Exhibits and Reports on Form 8-K (a). The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION - -------------- ----------- 31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L. Herlache, Chief Executive Officer, is attached hereto. 31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D. Jennerjohn, Chief Financial Officer, is attached hereto. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbenes-Oxley is attached hereto.
(b). Report on Form 8-K: Baylake Corp. filed a Report on Form 8-K dated June 7, 2004 to report the results of its annual meeting of shareholders. In addition, a report on Form 8-K dated May 5, 2004 was submitted under Item 12, Results of Operations and Financial Condition, reporting Baylake Corp released its earnings for the three months ended March 31, 2004; that report is not incorporated by reference into other filings. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BAYLAKE CORP. ------------------------------------- Date: August 12, 2004 /s/ Thomas L. Herlache ---------------------- ------------------------------------- Thomas L. Herlache President (CEO) Date: August 12, 2004 /s/ Steven D. Jennerjohn ---------------------- ------------------------------------- Steven D. Jennerjohn Treasurer (CFO)
37 EX-31.1 2 c87578exv31w1.txt CERTIFICATION UNDER SECTION 302 BY THOMAS L. HERLACHE, CEO EXHIBIT 31.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Thomas L. Herlache, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarter ended June 30, 2004 of Baylake Corp (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 12, 2004 /s/ Thomas L. Herlache - ---------------------- Thomas L. Herlache Chairman and CEO EX-31.2 3 c87578exv31w2.txt CERTIFICATION UNDER SECTION 302 BY STEVEN D. JENNERJOHN, CFO EXHIBIT 31.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Steven D. Jennerjohn, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarter ended June 30, 2004 of Baylake Corp (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) an 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 12, 2004 /s/ Steven D. Jennerjohn - ------------------------------------------------- Steven D. Jennerjohn Senior Vice President and Chief Financial Officer EX-32.1 4 c87578exv32w1.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER EXHIBIT 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Baylake Corp. (the "Company") on Form 10-Q for the three and six months ended June 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Thomas L. Herlache, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Quarterly Report on Form 10-Q of the Company for the three and six months ended June 30, 2004 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Thomas L. Herlache - ------------------------------------- Thomas L. Herlache President and Chief Executive Officer August 12, 2004 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Baylake Corp. and will be retained by Baylake Corp. and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 5 c87578exv32w2.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER EXHIBIT 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Baylake Corp. (the "Company") on Form 10-Q for the three and six months ended June 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Steven D. Jennerjohn, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Quarterly Report on Form 10-Q of the Company for the three and six months ended June 30, 2004 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Steven D. Jennerjohn - ----------------------------------- Steven D. Jennerjohn Senior Vice President and Chief Financial Officer August 12, 2004 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Baylake Corp. and will be retained by Baylake Corp. and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----