10-Q 1 c95168e10vq.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 MARCH 31, 2005 --------------------------------- 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 May 4, 2005: 7,697,777 shares BAYLAKE CORP. AND SUBSIDIARIES INDEX
PART I - FINANCIAL INFORMATION PAGE NO. -------- Item 1. Financial Statements Consolidated Balance Sheets (Unaudited) as of March 31, 2005 and December 31, 2004 3 Consolidated Statements of Income and Comprehensive Income (Unaudited) for the three months ended March 31, 2005 and 2004 4 Consolidated Statements of Changes in Stockholders' Equity (Unaudited) for the three months ended March 31, 2005 and 2004 5 Consolidated Statements of Cash Flows (Unaudited) for the three months ended March 31, 2005 and 2004 6-7 Notes to Consolidated Unaudited Financial Statements 8-10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11-32 Item 3. Quantitative and Qualitative Disclosures About Market Risk 32-33 Item 4. Controls and Procedures 33-34 PART II - OTHER INFORMATION Signatures 35 EXHIBIT INDEX Exhibit 31.1 Certification pursuant to Section 302 36 Exhibit 31.2 Certification pursuant to Section 302 38 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
BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) March 31, 2005 and December 31, 2004 (Amounts in thousands of dollars)
March 31, December 31, ------------ ------------ 2005 2004 ------------ ------------ ASSETS Cash and due from financial institutions $ 15,495 $ 20,727 Federal funds sold -- 5,445 ------------ ------------ Cash and cash equivalents 15,495 26,172 Securities available for sale 201,722 197,392 Loans held for sale 813 1,349 Loans, net of allowance after $10,279 and $10,445 773,600 746,783 Cash value of life insurance 22,257 21,561 Premises and equipment, net 26,457 24,777 Federal Home Loan Bank stock 7,803 7,697 Foreclosed assets, net 2,378 2,572 Goodwill 5,723 5,723 Accrued interest receivable 4,781 4,330 Other assets 9,806 9,392 ------------ ------------ Total assets $ 1,070,835 $ 1,047,748 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Non-interest-bearing $ 103,099 $ 120,511 Interest-bearing 726,859 724,030 ------------ ------------ Total deposits 829,958 844,541 Federal Home Loan Bank advances 115,190 100,192 Federal funds purchased and repurchase agreements 25,494 1,284 Subordinated debentures 16,100 16,100 Accrued expenses and other liabilities 8,387 8,272 Dividends payable -- 1,154 ------------ ------------ Total liabilities 995,129 971,543 Common stock, $5 par value, authorized 50,000,000; issued- 7,720,936 shares in 2005, 7,715,936 shares in 2004; outstanding- 7,697,777 shares in 2005, 7,692,777 shares in 2004 38,605 38,580 Additional paid-in capital 8,845 8,806 Retained earnings 29,704 28,275 Treasury stock (23,159 shares in 2005 and 2004) (625) (625) Accumulated other comprehensive income (loss) (823) 1,169 ------------ ------------ Total stockholders' equity 75,706 76,205 ------------ ------------ Total liabilities and stockholder equity $ 1,070,835 $ 1,047,748 ============ ============
See accompanying notes to Unaudited Consolidated Financial Statements. 3 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited) Three months ended March 31, 2005 and 2004 (Amounts in thousands of dollars except per share data)
2005 2004 ------- ------- Interest and dividend income Loans, including fees $11,663 $ 9,890 Taxable securities 1,729 1,576 Tax exempt securities 403 392 Federal funds sold and other 17 3 ------- ------- Total interest and dividend income 13,812 11,861 Interest expense Deposits 3,827 3,018 Federal funds purchased and repurchase agreements 173 112 Federal Home Loan Bank advances and other debt 737 479 Subordinated debentures 461 412 ------- ------- Total interest expense 5,198 4,021 ------- ------- NET INTEREST INCOME 8,614 7,840 Provision for loan losses 30 775 ------- ------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,584 7,065 Other income Fees from fiduciary activities 179 174 Fees from loan servicing 283 243 Fees for other services to customers 1,098 970 Gains from sales of loans 208 308 Increase in cash surrender value of life insurance 227 198 Other income 268 77 ------- ------- Total other income 2,263 1,970 Noninterest expenses Salaries and employee benefits 4,528 3,865 Occupancy expense 536 522 Equipment expense 307 369 Data processing and courier 278 283 Operation of other real estate 48 125 Other operating expenses 1,348 1,208 ------- ------- Total other expenses 7,045 6,372 ------- ------- INCOME BEFORE INCOME TAX EXPENSE 3,802 2,663 Income tax expense 1,218 767 ------- ------- NET INCOME $ 2,584 $ 1,896 ======= ======= COMPREHENSIVE INCOME $ 592 $ 3,306 ======= ======= Basic earnings per common share $ 0.34 $ 0.25 Diluted earnings per common share $ 0.33 $ 0.25
See accompanying notes to Unaudited Consolidated Financial Statements. 4 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) Three months ended March 31, (Amounts in thousands of dollars except for per share data)
Accumulated Common Stock Additional Other --------------------- Paid-in Retained Treasury Comprehensive Total Shares Amount Capital Earnings Stock Income Equity --------- --------- ---------- --------- --------- ------------- --------- BALANCE, JANUARY 1, 2004 7,604,977 $ 38,141 $ 8,163 $ 21,864 $ (625) $ 2,085 $ 69,628 Net income for the year -- -- -- 1,896 -- -- 1,896 Net changes in unrealized gain (loss) on securities available for sale, net of $793 deferred taxes -- -- -- -- -- 1,410 1,410 --------- Total comprehensive income 3,306 Stock options exercised 22,500 112 146 -- -- -- 258 Tax benefit from exercise of stock options -- -- 25 -- -- -- 25 Cash dividends declared ($0.14 per share) -- -- -- (1,067) -- -- (1,067) --------- --------- --------- --------- --------- --------- --------- BALANCE, MARCH 31, 2004 7,627,477 $ 38,253 $ 8,334 $ 22,693 $ (625) $ 3,495 $ 72,150 ========= ========= ========= ========= ========= ========= ========= BALANCE, JANUARY 1, 2005 7,692,777 $ 38,580 $ 8,806 $ 28,275 $ (625) $ 1,169 $ 76,205 Net income for the year -- -- -- 2,584 -- -- 2,584 Net changes in unrealized gain (loss) on securities available for sale, net of $(1,108) deferred taxes -- -- -- -- -- (1,992) (1,992) --------- Total comprehensive income 592 Stock options exercised 5,000 25 24 -- -- -- 49 Tax benefit from exercise of stock options -- -- 15 -- -- -- 15 Cash dividends declared ($0.15 per share) -- -- -- (1,155) -- -- (1,155) --------- --------- --------- --------- --------- --------- --------- BALANCE, MARCH 31, 2005 7,697,777 $ 38,605 $ 8,845 $ 29,704 $ (625) $ (823) $ 75,706 ========= ========= ========= ========= ========= ========= =========
See accompanying notes to Unaudited Consolidated Financial Statements. 5 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Three months ended March 31, 2005 and 2004 (Amounts in thousands of dollars)
2005 2004 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Reconciliation of net income to net cash provided by operating activities: Net income $ 2,584 $ 1,896 Adjustments to reconcile net income to net cash provided to operating activities: Depreciation and amortization 436 489 Provision for losses on loans 30 775 Net amortization of securities 163 135 Increase in cash surrender value of life insurance (226) (198) Federal Home Loan Bank stock dividend (106) (118) Net realized gain on sale of securities -- -- Net gain on sale of loans (208) (308) Proceeds from sale of loans held for sale 8,499 18,124 Origination of loans held for sale (7,754) (19,400) Net gain from disposal of other real estate (21) (52) Changes in assets and liabilities: Accrued interest receivable and other assets 256 (350) Accrued expenses and other liabilities 115 229 -------- -------- Net cash provided by operating activities 3,768 1,222 CASH FLOWS FROM INVESTING ACTIVITIES: Principal payments on securities available-for-sale 2,938 9,342 Purchase of securities available-for-sale (10,530) (12,524) Proceeds from sale of other real estate owned 215 283 Proceeds from sale of premises and equipment 157 -- Loan originations and payments, net (26,847) (18,201) Additions to premises and equipment (2,273) (2,020) Investment in bank-owned life insurance (470) -- -------- -------- Net cash used in investing activities (36,810) (23,120)
See accompanying notes to Unaudited Consolidated Financial Statements. 6 BAYLAKE CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Three months ended March 31, 2005 and 2004 (Amounts in thousands of dollars)
2005 2004 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net change in deposits $(14,583) $ (9,230) Net change in federal funds purchased and repurchase agreements 24,210 16,023 Proceeds from Federal Home Loan Bank advances 15,000 10,000 Repayments on Federal Home Loan Bank advances (2) (1) Payments on other borrowings and long-term debt -- (53) Proceeds from exercise of stock options 49 283 Cash dividends paid (2,309) (2,127) -------- -------- Net cash provided by financing activities 22,365 14,895 -------- -------- Net change in cash and cash equivalents (10,677) (7,003) Beginning cash and cash equivalents 26,172 24,226 -------- -------- ENDING CASH AND CASH EQUIVALENTS $ 15,495 $ 17,223 ======== ========
See accompanying notes to Unaudited Consolidated Financial Statements. 7 BAYLAKE CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2005 1. The accompanying consolidated financial statements should be read in conjunction with Baylake Corp.'s 2004 annual report on Form 10-K. The accompanying consolidated financial statements are unaudited. These interim financial statements are prepared in accordance with the requirements of Form 10-Q, and accordingly do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial information included in this report reflects all adjustments, consisting of normal recurring accruals, which are necessary for a fair statement of the financial position as of March 31, 2005 and December 31, 2004. The results of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be expected for the entire year. 2. To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, foreclosed assets, and fair values of financial instruments are particularly subject to change. 3. 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 three months ended March 31 (dollars in thousands, except per share amounts):
Three months ended March 31, 2005 2004 ---------- ---------- (NUMERATOR): Net income $ 2,584 $ 1,896 (DENOMINATOR): Weighted average number of common shares 7,695,721 7,612,356 outstanding-basic Dilutive effect of stock options 100,849 64,652 ---------- ---------- Weighted average of common shares outstanding 7,796,570 7,677,009 and assumed conversion-diluted BASIC EPS $ 0.34 $ 0.25 DILUTED EPS $ 0.33 $ 0.25
8 BAYLAKE CORP. AND SUBSIDIARIES 4. Baylake Corp. declared a cash dividend of $0.15 per share payable on March 15, 2005 to shareholders of record as of March 1, 2005. 5. The Company has a non-qualified stock option plan, which is described more fully in the Company's December 31, 2004 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 March 31, Amounts in thousands, except per share data ---------------------------- 2005 2004 --------- --------- Net income, as reported $ 2,584 $ 1,896 Less: Total stock-based employee compensation cost determined under the fair value based method, net of income taxes (14) (27) --------- --------- Pro forma net income 2,570 1,869 Earnings per share: Basic - as reported $ 0.34 $ 0.25 Basic - pro forma $ 0.33 $ 0.25 Diluted - as reported $ 0.33 $ 0.25 Diluted - pro forma $ 0.33 $ 0.24
The fair value of each option granted was estimated as of the date of grant using the Black-Scholes option pricing model. The resulting compensation cost was amortized over the vesting period. 6. Certain amounts reported in the March 31, 2004 Form 10-Q have been reclassified to conform to the March 31, 2005 presentation. 7. Effect of Newly Issued But Not Yet Effective Accounting Standards: FAS 123R requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the 9 BAYLAKE CORP. AND SUBSIDIARIES vesting period of the options. This will apply to awards granted or modified after the first year beginning after June 15, 2005. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. The Company has ceased issuing stock options under the current plan and thus expects no further grants. However, the plan is still in existence and the Company has reserved the right to grant additional options. Existing options that will vest after adoption date are expected to result in an immaterial amount of compensation expense during 2005 though 2008. SOP 03-3 requires that a valuation allowance for loans acquired in a transfer, including in a business combination, reflect only losses incurred after acquisition and should not be recorded at acquisition. It applies to any loan acquired in a transfer that showed evidence of credit quality deterioration since it was made. The effect of these new standards on the Company's financial position and results of operations is not expected to be material upon adoption. 10 PART 1 - FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Baylake is a full-service financial services company, providing a wide variety of loan, deposit and other banking products and services to its business, individual or retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Company is the bank holding company of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member bank of the Federal Reserve and Federal Home Loan Bank. 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 months ended March 31, 2005 and 2004 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. 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. 11 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: The allowance for loan losses ("ALL") is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and the estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. The allowance consists of specified and general components. The specific component relates to loans that are individually classified as impaired or loans other classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Goodwill: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of the acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment, and any such impairment will be recognized in the period identified. 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 state taxing authorities. 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 also implemented a program in 2003 for the audit of Wisconsin financial institutions who have 12 formed and contributed assets to subsidiaries located in Nevada; to date, the Company and its subsidiaries have not been audited on these matters. The Department sent letters in 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. For 2004 and going forward, 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. The Company continues to believe that it has reported income and paid Wisconsin taxes correctly in accordance with applicable tax laws and the Department's prior longstanding interpretations thereof, including interpretations issued specifically to it. However, in view of the Department's subsequent change in position (even if that change does not have a basis in law), the aggressive stance now being taken by the Department, the settlements by some other banks, and the potential effect that decisions by other similarly situated institutions may have on the Company's alternatives going forward, the Company has determined that it would be prudent to obtain and consider a settlement proposal from the Department; however, the Company has not yet received a specific proposal nor has any assessment been made against the Company or its subsidiaries. The Company will need to review any settlement proposal in more specific detail to quantify in any definitive way the Department's view of its exposure and to evaluate alternatives. Although there will likely be challenges to the Department's actions and interpretations, the Bank's net income would be reduced if the Department succeeds in its actions and interpretations. The Bank could also incur costs in the future to address any action taken against it by the Department. RESULTS OF OPERATIONS The following table sets forth the Company's net income and related summary information for the three-months periods ended March 31, 2005 and 2004, as well as comparisons between the respective periods. TABLE 1 SUMMARY RESULTS OF OPERATIONS ($ in thousands, except per share data)
Three months Three months ended ended % Increase or March 31, 2005 March 31, 2004 decrease -------------- -------------- ------------- Net income $ 2,584 $ 1,896 36.3% EPS-basic $ 0.34 $ 0.25 36.0% EPS-diluted $ 0.33 $ 0.25 32.0% Return on average assets 0.98% 0.78% 25.7%
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Three months Three months ended ended % Increase or March 31, 2005 March 31, 2004 decrease -------------- ------------- ------------ Return on average equity 13.49% 10.80% 24.9% Efficiency ratio (1) 63.03% 63.13% 0.2%
(1) Non-interest expense divided by sum of taxable equivalent net interest income plus non-interest income, excluding investment securities gains, net The increase in net income for the three-month periods is primarily due to increased net interest income, other income and a reduction in the provision for loan losses. This increase was partially offset by an increase in other expenses and income tax expense. Net Interest Income Net interest income is the largest component of the Company's operating income (net interest income on a tax-equivalent basis plus other non-interest income), accounting for 79.8% of total operating income for the three months ended March 31, 2005, as compared to 80.5% for the same period in 2004. 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 March 31, 2005 increased $792,000, or 9.8%, to $8.9 million from $8.1 million over the comparable period a year ago. The increase results from improvement in our net interest margin and from increased loan levels. 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 first quarter of 2005 was 3.66%, up 10 basis points ("bps") from 3.56% for the comparable period in 2004. This comparable period increase was attributable to an 8 bps increase in interest rate spread (the net result of a 48 bps increase in the yield on earning assets offset partially by a 40 bps increase in the cost of interest-bearing liabilities). As the Federal Reserve Board ("FRB") has steadily increased interest rates during the latter half of 2004 and the early part of 2005, average interest rates were higher in 2005 than in 2004. Interest rates rose steadily during the quarter with two rate increases totaling 50 bps between the comparable first quarter periods. The Company had positioned the balance sheet to be slightly asset sensitive (which means that assets will re-price faster than liabilities); thus, the rate increases impacted net interest income positively. The Company expects that in a gradually increasing interest rate environment, we would continue to anticipate that our income statement would benefit from asset sensitivity over the long term, although changes in the portfolio or the pace of increases could affect that trend 14 For the three months ended March 31, 2005, average-earning assets increased $61.4 million, or 6.7%, when compared to the same period last year. The Company recorded an increase in average loans of $40.3 million, or 5.6%, for the first quarter of 2005 compared to the same period a year ago. Loans have typically resulted in higher rates of interest income to the Company than have investment securities, which further positively affected income in the quarter. Interest rate spread is the difference between the tax-equivalent rate earned on average earning assets and the rate paid on average interest-bearing liabilities. The interest rate spread increased for the quarter ended March 31, 2005 when compared to the same period a year ago. The interest rate spread increased 8 bps to 3.40% at March 31, 2005 from 3.32% in the same quarter in 2004. While the average yield on earning assets increased 48 bps during the period, the average rate paid on interest-bearing liabilities increased 40 bps over the same period. The increase in the rates paid on interest-bearing liabilities occurred as a result of a higher cost of funding from deposits and other wholesale funding such as federal funds purchased and loans from the Federal Home Loan Bank. We would expect that trend to continue in light of the recent Federal Reserve Board interest rate increases. TABLE 2 NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS ($ In thousands) Three months ended March 31,
2005 2004 -------------------------------------- ------------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance expense rate Balance expense rate ---------- ---------- ---------- ---------- ---------- ---------- ASSETS Earning assets: Loans, net $ 766,068 $ 11,756 6.14% $ 725,786 $ 9,971 5.50% Taxable securities 169,410 1,729 4.08% 151,648 1,576 4.16% Tax exempt securities 35,243 611 6.95% 33,718 594 7.05% Federal funds sold and interest bearing due from banks 3,281 17 2.07% 1,437 3 0.84% ---------- ---------- ---------- ---------- ---------- ---------- Total earning assets 974,002 14,113 5.80% 912,589 12,144 5.32% ---------- ---------- ---------- ---------- ---------- ---------- Non-interest earning assets 76,598 70,516 ---------- ---------- Total assets $1,050,600 $ 983,105 ---------- ---------- LIABILITIES AND STOCKHOLDERS'EQUITY Interest-bearing liabilities: Total interest- bearing deposits 721,631 3,827 2.12% 678,190 3,018 1.78%
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2005 2004 -------------------------------------- ------------------------------------- Interest Average Interest Average Average income/ yield/ Average income/ yield/ Balance expense rate Balance expense rate ---------- ---------- ---------- ---------- ---------- ---------- Short-term borrowings 23,256 165 2.84% 33,172 110 1.33% Customer repurchase agreements 1,538 8 2.08% 1,024 2 0.78% Federal Home Loan Bank advances 102,024 737 2.89% 82,784 479 2.31% Subordinated debentures 16,100 461 11.45% 16,100 412 10.24% ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities $ 864,549 $ 5,198 2.40% $ 811,270 $ 4,021 2.00% ---------- ---------- ---------- ---------- ---------- ---------- Demand deposits 102,036 94,625 Accrued expenses and other liabilities 7,373 6,602 ---------- ---------- Stockholders' equity 76,642 70,608 ---------- ---------- Total liabilities and stockholders' equity $1,050,600 $ 983,105 ---------- ---------- Interest rate spread $ 8,915 3.40% $ 8,123 3.32% Net interest margin 3.66% 3.56% ---------- ----------
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 92.7% and 92.8%, respectively, for the first three months of 2005 and 2004, respectively. Provision for Loan Losses The provision for loan losses ("PFLL") is the cost of providing an allowance for probable incurred losses. Prior to the third quarter of 2004, the Company determined the allowance by risk rating loans that were classified as substandard or doubtful thru a grading process that was predicated on various risk rating matrices and the assignment of potential loss based on those ratings. In addition, the remaining loans in the portfolio were assigned risk weightings based on their various classifications. During the third quarter of 2004, the Company further enhanced its methodologies to individually review substandard and doubtful loans for impairment and bring other factors into the process to evaluate the ALL. The Company made these enhancements to more accurately reflect the risk inherent in the loan portfolio by engaging in the additional analysis. 16 As previously discussed, the allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. These current factors, include 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. As a result of this process, the PFLL for the first three months of 2005 was $30,000 as compared to a PFLL of $775,000 for the first three months in 2004. The calculation of the amount took into account net improvements in the loan portfolio in the period. Net loan charge-offs in the first three months of 2005 were $196,000 compared with net charge-offs of $283,000 for the same period in 2004. Net charge-offs as a percentage of average loans is a key measure of asset quality. Net charge-offs to average loans were 0.10% for the first three months of 2005 compared to 0.16% for the same period in 2004. For the three months ended March 31, 2005, non-accrual loans increased $2.4 million, in part as the result of a transfer to non-accrual of a $2.1 million commercial real estate credit from the watch list. As a result, there was not a material change in the amount of reserve allocated to this credit. At the end of April, this credit had been reduced to $1.1 million and was current. Restructured loans decreased significantly, primarily as a result of a $4.8 million credit that has improved in asset quality and has performed according to the modified loan terms and has been transferred to a performing loan status, as a result. Total non-performing loans therefore decreased $3.1 million in the quarter. TABLE 3 ALLOWANCE FOR LOAN LOSSES ($ in thousands)
For the three For the three months ended months ended March 31, 2005 March 31, 2004 -------------- -------------- Allowance for Loan Losses ("ALL) Balance at beginning of period $ 10,445 $ 12,159 Provision for loan losses 30 775 Charge-offs 336 410 Recoveries 140 127 Balance at end of period $ 10,279 $ 12,651 Net charge-offs ("NCOs:) $ 196 $ 283
As described more fully in Table 7 below, non-accrual loans increased during the period from December 31, 2004, however, the total amount of non-performing loans decreased by $3,052,000 and non-performing assets decreased by $3,246,000. Furthermore, despite the increase in non-accrual loans during the quarter ended March 31, 2005, the required allocation of the allowance for such loans increased only minimally resulting in a provision of $30,000 for the first quarter of 2005. 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 17 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" and "Non-Performing Loans, Potential Problem Loans and Other Real Estate" below for more information related to non-performing loans. Non-Interest Income Total non-interest income increased $293,000, or 14.9% to $2.3 million for the first quarter of 2005 when compared to the first quarter of 2004. The non-interest income to average assets ratio was 0.86% for the three months ended March 31, 2005 compared to 0.81% for the same period in 2004. The increase in non-interest income for the three-month periods is mainly due to increases in other services to customers and other income offset by a decrease in gains from sales of loans. Table 4 reflects the various components of non-interest income for the comparable quarters. TABLE 4 NON-INTEREST INCOME ($ in thousands)
Three months ended Three months ended % Change from prior March 31, 2005 March 31, 2004 year ------------------ ------------------ ------------------- Fees from fiduciary activities 179 174 2.9% Fees from loan servicing 283 243 16.5% Service charges on deposit accounts 725 655 10.7% Other fee income 187 167 12.0% Financial services income 186 148 25.7% Gains from sales of loans 208 308 (32.5%) Increase in cash surrender value of life insurance 227 198 14.6% Gain on sale of bank assets 179 0 NM Other income 89 77 15.6% ----- ----- ------ Total Other Income 2,263 1,970 14.9%
Service charges on deposit accounts increased $70,000 for the three-month period ended March 31, 2005 due in part to the implementation of an overdraft privilege program started in the third quarter of 2004 and other price increases implemented during the latter part of 2004. In the first quarter of 2005, gains from sales of loans were affected by a slowdown in refinancing activity throughout the industry due to higher mortgage rates. In comparison, the same period in 2004 saw slightly higher levels of loan refinancing as a result of the historically low interest rate environment. Gains from sales of loans decreased $100,000 between the comparable quarters of 2005 and 2004. The decrease was driven primarily by secondary mortgage and commercial loan production (loan production to be sold to the secondary market) and resulting 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 60.0% between the comparable first three- 18 month periods ($7.7 million in the first three months of 2005 versus $19.4 million in the first three months of 2004). For the three-month period ended March 31, 2005, the increase in other income was related to a gain on sale of stock of $179,000 in connection with a third party acquisition of Pulse (an ATM operator/provider) in which the Bank held shares. Financial service income increased $38,000, or 25.7%, as a result of additional business generated and aided by favorable market conditions. Non-Interest Expense Non-interest expense increased $673,000 or 10.6%, to $7.0 million for the three months ended March 31, 2005 compared to the same period in 2004. The non-interest expense to average assets ratio was 2.68% for the three months ended March 31, 2005 compared to 2.61% for the same period in 2004. Net overhead expense is total non-interest expense less total non-interest income excluding securities gains. The net overhead expenses to average assets ratio was 1.82% for the three months ended March 31, 2005 compared to 1.80% for the same period in 2004. The efficiency ratio is total non-interest expense as a percentage of the sum of net-interest income on a fully taxable equivalent basis and total non-interest income. The efficiency ratio for the three months ended March 31, 2005 was 63.03% compared to 63.13% for the same period in 2004. TABLE 5 NON-INTEREST EXPENSE ($ in thousands)
Three months ended Three months ended % Change from prior March 31, 2005 March 31, 2004 year ------------------ ------------------ ------------------- Salaries and employee benefits 4,528 3,865 17.2% Occupancy 536 522 2.7% Equipment 307 369 (16.8%) Data processing and courier 278 283 (1.8%) Operation of other real estate 48 125 (61.6%) Business development and advertising 204 127 60.6% Charitable contributions 92 102 (9.8%) Stationary and supplies 112 109 2.8% Director fees 82 98 (16.3%) FDIC 27 29 (6.9%) Mortgage servicing rights amortization 62 66 (6.1%) Legal and professional 176 92 91.3% Other operating 593 585 1.4% ----- ----- ------ Total non-interest expense 7,045 6,372 10.6%
19 Salaries and employee benefits showed an increase of $663,000, or 17.2%, to $4.5 million for the first quarter of 2005 compared to the same period in 2004. The number of full-time equivalent employees was 308 as of March 31, 2005 compared to 300 as of March 31, 2004. For the three months ended March 31, 2005, salary-related expenses increased $132,000, or 4.9%, due principally to merit increases between the years. In the first quarter, the Company implemented the Baylake Bank Supplemental Executive Retirement Plan ("Plan"), which is intended to provide certain management and highly compensated employees of the Bank who have contributed, and are expected to continue to contribute, to the Bank's success by providing for deferred compensation in addition to that available under the Bank's other retirement programs. It amounted to approximately $300,000 in expenses related to the vested portion of the Plan contributions in the first quarter of 2005. Accrued bonus expense and 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 2005 and for 2006. Management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to continue in future years. Expenses related to the operation of other real estate owned decreased $77,000 to $48,000 for the 2005 three-month period compared to the same period in 2004. Included in these expenses were net gains taken on the sale of other real estate owned amounting to $43,000 for the first three months of 2005 compared to net gains taken on sale of $52,000 for the same period in 2004. In addition, costs related to the holding of other real estate owned properties decreased $86,000 to $91,000 for the first three months of 2005. Legal and professional expense for 2005 increased substantially, by $84,000, to $176,000. The increase was the result of increased costs relative to SEC compliance primarily as a result of enhanced requirements imposed by the Sarbanes-Oxley Act of 2002 and related SEC actions. Income Taxes Income tax expense for the Company for the three months ended March 31, 2005 was $1.2 million, an increase of $451,000, or 58.8%, compared to the same period in 2004. The higher tax expense in 2005 reflected the Company's increase in before tax earnings. The Company's effective tax rate (income tax expense divided by income before taxes) was 32.0% for the three months ended March 31, 2005 compared with 28.8% for the same period in 2004. The effective tax rate of 32.0% consisted of a federal effective tax rate of 27.8% and Wisconsin State effective tax rate of 4.2%. Taxable income increased while tax-exempt interest income from municipal investments and income from BOLI did not increase in a like manner. Income tax expense recorded in the consolidated statements of income involves 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 various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense 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. See "Critical Accounting Policies-Income Tax Accounting" above regarding Wisconsin tax matters which may affect our income tax expense. 20 BALANCE SHEET ANALYSIS Loans At March 31, 2005, total loans increased $26.7 million, or 3.5%, to $783.9 million from $757.2 million at December 31, 2004. Growth in the Company's loan portfolio resulted primarily from an increase in real estate commercial loans to $437.4 million at March 31, 2005 compared to $424.7 million at December 31, 2004. In addition, growth in real estate construction loans increased to $93.2 million at March 31, 2005 compared to $80.4 million at December 31, 2004. Growth in commercial real estate mortgages and commercial loans occurred principally as a result of the Company's expansion efforts (primarily in the Green Bay market) and the strong economic growth in that market. The following table reflects the composition (mix) of the loan portfolio (dollars in thousands): TABLE 6 LOAN PORTFOLIO ANALYSIS ($ in thousands)
March 31, December 31, Percent 2005 2004 change ------------ ------------ ------------ Amount of loans by type Real estate-mortgage Commercial $ 437,447 $ 424,712 3.0% 1-4 family residential First liens 79,646 78,321 1.7% Junior liens 20,671 20,244 2.1% Home equity 34,918 35,785 (2.4%) Commercial, financial and agricultural 86,427 83,787 3.2% Real estate-construction 93,211 80,384 16.0% Installment Credit cards and related plans 2,117 2,152 (1.6%) Other 11,855 11,784 0.6% Obligations of states and political subdivisions 17,993 20,457 (12.0%) Less: deferred origination fees, net of costs 406 398 2.0% ------------ ------------ ------------ Total $ 783,879 $ 757,228 3.5%
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 for probable incurred 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 controlled 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 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 indicated in Table 3 above, the ALL at March 31, 2005 was $10.3 million compared with $10.4 million at the end of 2004. This was based on management's analysis of the loan portfolio risk at March 31, 2005. As such a provision expense of $30,000 was recorded for the quarter ended 21 March 31, 2005. The quarter to date provision has decreased by $745,000 compared to the same period in 2004, as discussed previously. The provision for loan losses is predominately a function of management's evaluation of the loan portfolio, with particular emphasis directed toward non-performing and other potential problem loans. During these evaluations, consideration is also given to such factors as management's evaluation of specific loans, the level and composition of impaired loans, other non-performing loans, historical loan experience, results of examinations by regulatory agencies and various other factors. On a quarterly basis, management reviews the adequacy of the ALL. Commercial credits are graded by the loan officers and the loan review function validates the officers' grades. In the event that the loan review function downgrades the loan, it is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are know differences (i.e., collateral value is nominal, etc.). To establish the appropriate level of the allowance, a sample of loans (including impaired and non-performing loans) are reviewed and classified as to potential loss exposure. Based on an estimation computed pursuant to the requirements of Financial Accounting Standards Board ("FASB") Statement No. 5, "Accounting for Contingencies," and FASB Statements No. 114 and 118, "Accounting by Creditors for Impairment of a Loan," the analysis of the ALL consists of two components: (i) specific credit allocation established for expected losses resulting from analysis developed through specific credit allocations on individual loans for which the recorded investment in the loan exceeds its fair value; (ii) general portfolio allocation based on historical loan loss experience for each loan category and adjusted for economic conditions as well as specific and other factors in the markets in which the Company operates. In prior years the Company did not consistently use subjective reserves based on general economic conditions and specific economic factors as a component of the ALL analysis, but rather used the unallocated portion of the ALL to recognize this inherent factor. During the third quarter of 2004, as part of its review of internal control over financial reporting and efforts to improve that control, the Company refined the process to calculate the ALL to use the subjective factors and thus the previously unallocated portion was allocated to the various loan categories. Management believes that there would be no change in the balance of the ALL if this approach was used in all of the years presented. The specific credit allocation of the ALL is based on a regular analysis of loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the market price of the loan, or, if the loan is collateral dependent, the fair value of the underlying collateral less cost of sale. The general portfolio allocation component of the ALL is determined statistically using a loss migration analysis that examines historical loan loss experience. The loss migration analysis is performed quarterly and loss factors are updated regularly based on actual experience. The general portfolio allocation element of the ALL also includes consideration of the amounts necessary for concentrations and changes in portfolio mix and volume. The ALL is based on estimates, and ultimate losses will vary from current estimates. These estimates are reviewed monthly, and as adjustments, either positive or negative, become 22 necessary, a corresponding increase or decrease is made in the provision for loan losses. The composition of the loan portfolio has not significantly changed since year-end 2004. Management remains watchful of credit quality issues and believes that issues within the portfolio are reflective of the challenging economic environment experienced over the past few years. Should the economic climate deteriorate from current levels, borrowers may experience difficulty, and the level of non-performing loans, charge-offs and delinquencies could rise and require further increases in the provision. 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. While there exists probable asset quality problems in the loan portfolio, management believes sufficient reserves have been provided in the ALL to absorb probable incurred losses in the loan portfolio at March 31, 2005. 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 are 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. 23 TABLE 7 NON-PERFORMING ASSETS ($ in thousands)
At or for the At or for the At or for the period ended period ended period ended March 31, 2005 March 31, 2004 December 31, 2004 ----------------- ----------------- ----------------- Nonperforming Assets: Nonaccrual loans $ 8,288 $ 10,574 $ 5,920 Accruing loans past due 90 days or more 0 0 0 Restructured loans 1,111 5,163 6,531 ----------------- ----------------- ----------------- Total nonperforming loans ("NPLs") $ 9,399 $ 15,737 $ 12,451 Other real estate owned 2,378 2,816 2,572 ----------------- ----------------- ----------------- Total nonperforming assets ("NPAs") $ 11,777 $ 18,553 $ 15,023 Ratios: ALL to NCO's (annualized) 12.93 11.11 3.15 NCO's to average loans (annualized) 0.10% 0.16% 0.45% ALL to total loans 1.31% 1.73% 1.38% NPL's to total loans 1.20% 2.16% 1.64% NPA's to total assets 1.10% 1.87% 1.43% ALL to NPL's 109.36% 80.39% 83.89%
As indicated in Table 7, non-performing loans at March 31, 2005 were $9.4 million compared to $12.5 million at December 31, 2004. Non-accrual loans represented $8.3 million of the total non-performing loans. Real estate non-accrual loans accounted for $7.5 million of the total, of which $1.1 million was residential real estate, $2.1 million was real estate construction and $4.3 million was commercial real estate, while commercial and industrial non-accrual loans total $723,000. Of the restructured loans at March 31, 2005, approximately $470,000 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. Restructured loans were $1.1 million at March 31, 2005 compared with $6.5 million at year-end 2004. As a result the ratio of non-performing loans to total loans at March 31, 2005 was 1.20% compared to 1.64% at end of year 2004. The Company's ALL was 109.4% of total non-performing loans at March 31, 2005 compared to 83.9% at end of year 2004. Non-performing assets (non-performing loans plus other real estate owned assets) at March 31, 2005 were $11.8 million compared to $15.0 million at December 31, 2004. Other real estate owned, which represents property that the Company acquired through foreclosure or in satisfaction of debt, consisted of two residential and twelve commercial properties totaling $2.4 million. Other real estate owned at December 31, 2004 totaled $2.6 million and consisted of sixteen 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 24 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 March 31, 2005, potential problem loans amounted to $2.5 million compared to a total of $9.3 million at December 31, 2004. Investment Portfolio The investment portfolio is intended to provide the Company with adequate liquidity, flexibility in asset/liability management and, lastly, an increase in its earning potential. At March 31, 2005, the investment portfolio (which includes investment securities available for sale) increased $4.3 million, or 2.2%, to $201.7 million from $197.4 million at December 31, 2004. At March 31, 2005 and December 31, 2004, the investment portfolio represented 18.8% of total assets. Securities available for sale consist of the following: TABLE 8 INVESTMENT SECURITY ANALYSIS At March 31, 2005 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. agencies 517 994 59,741 Mortgage-backed securities 13 2,057 95,689 Obligations of states & political subdivisions 1,233 109 38,120 Private placement 76 0 1,070 Other securities 0 0 7,102 ---------- ---------- ---------- Total securities available for sale $ 1,839 $ 3,160 $ 201,722
25 At December 31, 2004 ($ in thousands)
Gross Gross Unrealized Unrealized Gains Losses Fair Value ---------- ---------- ---------- Securities available for sale Obligations of U.S. Treasury & other U.S. Agencies $ 965 $ 214 $ 59,547 Mortgage-backed securities 190 794 99,360 Obligations of states & political subdivisions 1,556 0 33,973 Private placement 76 0 1,070 Other securities 0 0 3,442 ---------- ---------- ---------- Total investment securities $ 2,787 $ 1,008 $ 197,392
Deposits Total deposits at March 31, 2005 decreased $14.6 million, or 1.7%, to $830.0 million from $844.5 million at December 31, 2004. Non-interest bearing deposits at March 31, 2005 decreased $17.4 million, or 14.5%, to $103.1 million from $120.5 million at December 31, 2004. Interest-bearing deposits at March 31, 2005 increased $2.8 million, or 0.4%, to $726.9 million from $724.0 million at December 31, 2004. Brokered CD's totaled $182.8 million at March 31, 2005 compared to $175.4 million at December 31, 2004. 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. 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 2005 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 2005 and in 2006 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. Borrowings Federal funds purchased and securities under agreements to repurchase at March 31, 2005 increased $24.2 million to $25.5 million from $1.3 million at December 31, 2004. Federal funds purchased increased from no funds purchased at December 31, 2004 to $23.7 million at March 31, 26 2005 accounting for the majority of the increase. These have increased to fund the growth in the loan portfolio which was coupled with a decrease in core deposits during the quarter ended March 31, 2005. Federal Home Loan Bank Advances totaled $115.2 million at March 31, 2005 compared to $100.2 million at December 31, 2004. Typically, borrowings increase in order to fund growth in the loan portfolio in periods when borrowings increase more rapidly than deposits. 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. The Company anticipates it will continue to use wholesale funding sources of this nature, if these borrowings add incrementally to overall profitability. 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, formed by the Company. The aggregate principal amount of the debentures due 2031, to the trust is $16,597,940. For additional details, please make reference to the Consolidated Financial Statements and the accompanying footnotes on the Company's Form 10-K for the year 2004. CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT LIABILITIES The Company utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2004 for discussion with respect to the Company's quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in Form 10-K have not materially changed since that report was filed. The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments: TABLE 9 LENDING RELATED COMMITMENTS ($ in thousands)
March 31, 2005 December 31, 2004 ----------------- ----------------- Commitments to fund home equity line loans $ 53,209 $ 45,101 Commitments to fund commercial real estate loans 4,113 5,314 Commitments unused on various other lines of credit loans 144,366 135,889 ----------------- ----------------- Total commitments to extend credit $ 201,688 $ 186,304 Financial standby letters of credit $ 22,921 $ 23,428
27 The following table summarizes the Company's significant contractual obligations and commitments at March 31, 2005: TABLE 10 CONTRACTUAL OBLIGATIONS ($ in thousands)
(IN THOUSANDS) WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL -------------- ------------- --------- --------- ------------- -------- Federal funds purchased and repurchase agreements $ 25,494 $ 0 $ 0 $ 0 $ 25,494 Federal Home Loan Bank advances 90,000 0 190 25,000 115,190 Subordinated debentures 0 0 0 16,100 16,100 Purchase obligations-facilities 2,300 0 0 0 2,300 Operating leases 94 246 183 0 523 -------- -------- -------- -------- -------- Total $117,888 $ 246 $ 373 $ 41,100 $159,607
LIQUIDITY Liquidity management refers to the ability of the Company to ensure that cash is available in a 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 $1.2 million for the first three months of 2005 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 $2.3 million in the first three months of 2005. 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 28 ability to use its loan and investment portfolios as collateral for secured borrowings and strong capital positions. Maturing investments have been a primary source of liquidity at the Bank. For the three months ended March 31, 2005, principal payments totaling $2.9 million were received on investments. $10.5 million in investments were purchased in the first three months of 2005. This resulted in net cash of $7.6 million used in investing activities for the first three months of 2005. At March 31, 2005 the investment portfolio contained $155.4 million of U.S. Treasury and federal agency backed securities representing 77.1% of the total investment portfolio. These securities tend to be highly marketable. Deposit growth is typically another source of liquidity for the Bank in the latter half of each year, although deposits typically shrink in the first half resulting in a use of cash. As a financing activity reflected in the March 31, 2005 Consolidated Statements of Cash Flows, deposits decreased and resulted in $14.6 million of cash outflow during the first three months of 2005. The Company's overall deposit base decreased 1.7% for the three months ended March 31, 2005. Deposit growth is generally 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 $240.1 million, or 30.6%, 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 at March 31, 2005, federal funds purchased and securities sold under agreements to repurchase totaled $25.5 million compared to $1.3 million at the end of 2004. 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 long-term, are another source of funds. They total $115.2 million at March 31, 2005 and $100.2 million at December 31, 2004. The Bank's liquidity resources were sufficient in the first three months of 2005 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 three months of 2005, 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. 29 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, 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 March 31, 2005 decreased $499,000 or 0.7% to $75.7 million, compared with $76.2 million at end of year 2004. The decrease in stockholders' equity in 2005 was primarily composed of the change in unrealized losses on available for sale securities and the payment of dividends, partially offset by retained earnings and proceeds from the exercise of stock options. The change in unrealized losses on available for sale securities amounted to $2.0 million for the first three months of 2005; this change resulted the effects of the increasing interest rate environment. Total dividends paid increased to $2.3 million in the quarter from $2.1 million in 2004, primarily as a result of an increase in the per share dividends rate to $0.15 from $0.14. Stockholders' equity to assets at March 31, 2005 was 7.07% compared to 7.27% at the end of 2004. 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 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 March 31, 2005 and December 31, 2004, 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 March 31, 2005, 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 three months of 2005 were $0.15 per share compared with $0.14 in 2004. The Company provided a 7.2% increase in normal dividends per share in 2005 over 2004 as a result of earnings for 2005. Total funds utilized in the payment of dividends was $2.3 million in the first three months of 2005, as compared to $2.1 million in the corresponding period of 2004. 30 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 three months of 2005. 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. 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 March 31, 2005 and December 31, 2004, 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 March 31, 2005 and December 31, 2004: TABLE 11 CAPITAL RATIOS ($ in thousands)
Actual For Capital Adequacy To Be Well Purposes Capitalized under Prompt Corrective Action Provisions ------------------ -------------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of March 31, 2005 Total Capital (to Risk Weighted Assets) Company 96,776 10.71% 72,259 8.00% N/A N/A
31
Actual For Capital Adequacy To Be Well Purposes Capitalized under Prompt Corrective Action Provisions ------------------ -------------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- Bank 93,071 10.32% 72,151 8.00% 90,188 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 86,497 9.58% 36,129 4.00% N/A N/A Bank 82,792 9.18% 36,075 4.00% 54,113 6.00% Tier 1 Capital (to Average Assets) Company 86,497 8.29% 41,760 4.00% N/A N/A Bank 82,792 7.93% 41,760 4.00% 52,200 5.00% As of December 31, 2004 Total Capital (to Risk Weighted Assets) Company 95,433 10.95% 69,791 8.00% N/A N/A Bank 91,521 10.53% 69,580 8.00% 86,975 10.00% Tier 1 Capital (to Risk Weighted Assets) Company 84,988 9.75% 34,895 4.00% N/A N/A Bank 81,076 9.33% 34,790 4.00% 52,185 6.00% Tier 1 Capital (to Average Assets) Company 84,988 8.27% 41,129 4.00% N/A N/A Bank 81,076 7.91% 41,025 4.00% 51,282 5.00%
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. 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 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. 32 As of March 31, 2005, 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, 2004, as described in the Company's 2004 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 March 31, 2005. TABLE 12 INTEREST SENSITIVITY ($ in thousands)
Change in Net Interest Income over One Year Horizon -------------------------------------------------------------------------- At March 31, 2005 At December 31, 2004 Change in levels of ---------------------------------- ------------------------------------ interest rates Dollar change Percentage change Dollar change Percentage change ------------- ----------------- ------------- ----------------- +200 bp $1,559 4.2% $2,357 6.3% +100 bp 713 1.9% 1,092 2.9% Base 0 0% 0 0% -100 bp (1,180) (3.2%) (1,756) (4.7%) -200 bp (2,544) (6.9%) (3,656) (9.7%)
As shown above, at March 31, 2005, the effect of an immediate 200 basis point increase in interest rates would increase the Company's net interest income by $1.6 million or 4.2%. The effect of an immediate 200 basis point reduction in rates would decrease the Company's net interest income by $2.5 million or 6.9%. 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 March 31, 2005. 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. 33 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 with the exception of enhancements made during the quarter to the calculation of the allowance for loan loss reserve. Such enhancement is explained in Item 2, Management's Discussion and Analysis found in the sections entitled "Provision for Loan Losses" and "Balance Sheet Analysis-Risk Management and the Allowance for Loan Losses" which discussions are incorporated by reference in this item. 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. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS 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.
34 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 Sarbanes-Oxley is attached hereto.
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: May 10, 2005 /s/ Thomas L. Herlache ------------ ------------------------------- Thomas L. Herlache President (CEO) Date: May 10, 2005 /s/ Steven D. Jennerjohn ------------ ------------------------------- Steven D. Jennerjohn Treasurer (CFO) 35