10-Q 1 k88698e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 09/30/04 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934 For the quarterly period ended September 30, 2004, or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Transition Period from ________ to _________ Commission File No. 0-17000 COMMERCIAL NATIONAL FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Michigan 38-2799780 (State of Incorporation) (IRS Employer Identification No.) 101 North Pine River Street, Ithaca, Michigan 48847 (address of principal executive offices) (ZIP Code) Registrant's telephone number, including area code: (989) 875-4144 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange Act). YES [ ] NO [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at October 22, 2004 ----- ------------------------------- Common Stock 4,097,777 No Par Value INDEX PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003 (Page 3) Consolidated Statements of Income and Other Comprehensive Income (unaudited) for the three and nine months ended September 30, 2004 and September 30, 2003 (Page 4) Consolidated Statements of Changes in Shareholders' Equity (unaudited) for the nine months ended September 30, 2004 and September 30, 2003 (Page 5) Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2004 and September 30, 2003 (Page 6) Notes to Consolidated Financial Statements (unaudited) (Page 7-9) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 10-13) Item 3. Quantitative and Qualitative Disclosures about Market Risk (Page 13-15) Item 4. Controls and Procedures (Page 15) PART II OTHER INFORMATION Item 2. Unregistered Sales of Equity Securities and Use of Proceeds Item 6. Exhibits (Page 17) SIGNATURES (Page 18)
COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 1: FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS
September 30, December 31, 2004 2003 ------------- ------------- (Unaudited) ASSETS Cash and due from $ 4,580,199 $ 6,113,498 Federal funds sold 2,392 644,807 Other interest bearing deposits 2,016,425 1,961,444 ------------- ------------- Total cash and cash equivalents 6,599,016 8,719,749 Securities available for sale 21,007,131 23,029,107 Securities held to maturity (fair value $2,104,242- September 30, 2004; $3,171,283-December 31, 2003) 2,038,706 3,047,763 Federal Home Loan Bank stock, at cost 1,910,000 1,710,700 Gross loans receivable 204,698,389 194,389,682 Allowance for loan losses (2,437,117) (1,970,309) ------------- ------------- Net loans 202,261,272 192,419,373 Bank owned life insurance 3,975,503 3,736,505 Premises and equipment, net 3,904,713 3,933,347 Accrued interest receivable and other assets 2,163,169 3,191,703 ------------- ------------- Total assets $ 243,859,510 $ 239,788,247 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Deposits Non-interest bearing demand $ 22,896,009 $ 23,203,653 Interest-bearing demand 27,337,102 29,141,354 Savings 61,523,479 62,028,217 Time 54,245,693 55,191,313 ------------- ------------- Total deposits 166,002,283 169,564,537 Securities sold under agreements to repurchase 13,526,736 11,766,630 Other short-term borrowings 379,164 412,389 Federal Home Loan Bank advances 37,284,786 32,104,222 Accrued expenses and other liabilities 1,730,012 1,657,642 ------------- ------------- Total liabilities 218,922,981 215,505,420 Shareholders' equity Common stock and paid-in-capital, no par value: 5,000,000 shares Authorized; shares issued and outstanding September 30, 2004- 4,083,278 and December 31, 2003-4,052,480 24,450,290 24,117,375 Accumulated earnings/(deficit) 339,136 (112,306) Accumulated other comprehensive income, net of tax 147,103 277,758 ------------- ------------- Total shareholders' equity 24,936,529 24,282,827 ------------- ------------- Total liabilities and shareholders' equity $ 243,859,510 $ 239,788,247 ============= =============
See accompanying notes 3 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three Months Nine Months Ended September 30, Ended September 30, 2004 2003 2004 2003 Interest and dividend income Loans, including fees $ 3,335,239 $ 3,283,747 $ 9,424,155 $ 9,503,415 Taxable securities 126,081 176,486 420,255 539,648 Nontaxable securities 72,938 90,415 240,417 297,219 Federal funds sold 10,575 10,207 30,038 77,236 Federal Home loan Bank stock dividends 19,647 19,741 60,462 64,099 Interest on other deposits 3,116 2,315 6,664 12,730 ----------- ----------- ------------ ------------ Total interest and dividend income 3,567,596 3,582,911 10,181,991 10,494,347 Interest expense Deposits 523,900 560,532 1,618,149 1,901,464 Securities sold under agreements to repurchase 43,977 33,731 102,882 119,167 Federal Home Loan Bank advances 374,577 379,753 1,079,587 1,178,106 Other 784 640 1,910 2,059 ----------- ----------- ------------ ------------ Total interest expense 943,238 974,656 2,802,528 3,200,796 Net interest income 2,624,358 2,608,255 7,379,463 7,293,551 Provision for loan losses 90,000 431,000 270,000 1,781,000 ----------- ----------- ------------ ------------ Net interest income after provision for loan losses 2,534,358 2,177,255 7,109,463 5,512,551 Noninterest income Service charges and fees 119,936 124,365 337,573 358,774 Net gain on loan sales 72,165 238,554 175,364 779,685 Receivable financing fees 31,751 36,840 126,437 121,266 Other 118,467 372,182 403,791 476,285 ----------- ----------- ------------ ------------ Total noninterest income 342,319 771,941 1,043,165 1,736,010 ----------- ----------- ------------ ------------ Noninterest expense Salaries and employee benefits 985,373 961,804 2,948,386 2,795,473 Occupancy and equipment 329,062 292,474 997,780 914,967 FDIC insurance 6,260 7,245 19,189 21,429 Printing, postage and supplies 51,417 67,639 181,955 205,570 Professional and outside services 90,893 118,053 266,269 310,312 Other 334,119 321,545 919,052 837,860 ----------- ----------- ------------ ------------ Total non-interest expense 1,797,124 1,768,760 5,332,631 5,085,611 ----------- ----------- ------------ ------------ Income before income tax expense 1,079,553 1,180,436 2,819,997 2,162,950 Income tax expense 318,000 362,000 819,000 576,000 ----------- ----------- ------------ ------------ Net income $ 761,553 $ 818,436 $ 2,000,997 $ 1,586,950 =========== =========== ============ ============ Net change in unrealized gains on securities available for sale $ 136,849 $ (265,940) $ (197,962) $ (185,751) Tax effects (46,529) 90,419 67,307 63,155 ----------- ----------- ------------ ------------ Total comprehensive income $ 851,873 $ 642,915 $ 1,870,342 $ 1,464,354 =========== =========== ============ ============ Per share information Basic earnings $ .19 $ .20 $ .49 $ .39 Diluted earnings $ .19 $ .20 $ .49 $ .39 Dividends declared $ .12 $ .13 $ .38 $ .40
See accompanying notes 4 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Nine Months Ended September 30, 2004 and September 30, 2003 (Unaudited)
Accumulated Shares Common Retained Other Issued Stock and Earnings/ Comprehensive Total and Paid in (Accumulated Income/(Loss), Shareholder' Outstanding Capital Deficit) Net of Tax Equity ----------- ------------- ------------- -------------- ------------- Balance at January 1, 2003 3,801,421 $ 23,255,499 $ 3,908 $ 444,565 $ 23,703,972 Comprehensive income: Net income 1,586,950 1,586,950 Net change in unrealized gains/(losses) on securities available for sale (185,751) (185,751) Tax effect 63,155 63,155 ------------- Total comprehensive income 1,464,354 Cash dividends declared, $.40 per share (1,608,845) (1,608,845) Issued under dividend reinvestment plan 53,086 629,371 629,371 Issued under stock option plans 48 318 318 Issued under employee benefit plan 3,982 48,643 48,643 Repurchase and retirement of shares (16,334) (197,484) (197,484) --------- ------------- ------------- -------------- ------------- Balance at September 30, 2003 3,842,203 $ 23,736,347 $ (17,987) $ 321,969 $ 24,040,329 ========= ============= ============= ============== =============
Accumulated Shares Common Retained Other Issued Stock and Earnings/ Comprehensive Total and Paid in (Accumulated Income/(Loss), Shareholder' Outstanding Capital Deficit) Net of Tax Equity ----------- ------------- ------------- -------------- ------------- Balance at January 1, 2004 4,052,480 $ 24,117,375 $ (112,306) $ 277,758 $ 24,282,827 Comprehensive income: Net income 2,000,997 2,000,997 Net change in unrealized gains/(losses) on securities available for sale (197,962) (197,962) Tax effect 67,307 67,307 ------------- Total comprehensive income 1,870,342 Cash dividends declared, $.38 per share (1,549,555) (1,549,555) Issued under dividend reinvestment plan 49,947 556,794 556,794 Issued under stock option plans 1,700 11,050 11,050 Issued under employee benefit plan 4,395 55,969 55,969 Repurchase and retirement of shares (25,244) (290,898) (290,898) --------- ------------- ------------- -------------- ------------- Balance at September 30, 2004 4,083,278 $ 24,450,290 $ 339,136 $ 147,103 $ 24,936,529 ========= ============= ============= ============== =============
See accompanying notes 5 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended September 30, 2004 2003 ------------ ------------ Cash flows from operating activities Net income $ 2,000,997 $ 1,586,950 Adjustments to reconcile net income to net cash from operating activities Provision for loan losses 270,000 1,781,000 Net gains on loan sales (175,364) (779,685) Originations of loans held for sale (7,117,622) (31,849,988) Proceeds from sales of loans held for sale 7,292,986 32,629,673 Net (gain) loss on sale of other real estate and repossessed assets 4,436 (258,619) Stock dividends paid on Federal Home Loan Bank stock (60,300) (42,500) Bank owned life insurance (134,002) (129,015) Depreciation, amortization and accretion 567,732 522,945 Net change in accrued interest receivable and other assets 876,268 (346,128) Net change in accrued expenses and other liabilities 149,722 272,405 ------------ ------------ Net cash from operating activities 3,674,853 3,387,038 Cash flow from investing activities Purchases of securities available for sale (9,640,185) (15,779,027) Purchases of Federal Home Loan Bank stock (139,000) - Proceeds from maturities of securities available for sale 11,292,744 12,612,198 Proceeds from maturities of securities held to maturity 1,005,000 1,530,000 Net change in loans (10,111,899) (7,136,830) Purchases of premises and equipment (363,586) (602,131) Proceeds from sale of other real estate and repossessed activities 110,141 1,768,812 ------------ ------------ Net cash from investing activities (7,846,785) (7,606,978) Cash flow from financing activities Net change in deposits (3,562,254) (474,459) Net change in securities sold under agreements to repurchase 1,760,106 (149,391) Net change in U.S. treasury demand notes (33,225) (326,036) Proceeds from Federal Home Loan Bank advances 16,000,000 3,000,000 Repayment of Federal Home Loan Bank advances (10,819,436) (5,915,396) Repurchase and retirement of shares of common stock (290,898) (197,484) Dividends paid (1,626,907) (1,602,977) Proceeds from sale of common stock and fractional shares paid 623,813 678,332 ------------ ------------ Net cash from financing activities 2,051,199 (4,987,411) ------------ ------------ Net change in cash and cash equivalents (2,120,733) (9,207,351) Cash and cash equivalents, at beginning of period 8,719,749 19,269,814 ------------ ------------ Cash and cash equivalents, at end of period $ 6,599,016 $ 10,062,463 ============ ============ Cash paid during the period for Interest $ 2,826,112 $ 3,247,715 Federal income taxes $ 20,000 $ 684,000
See accompanying notes 6 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1-Summary of Significant Accounting Policies Basis of Presentation The accompanying unaudited consolidated financial statements were prepared in accordance with Rule 10-01 of Regulation S-X and the instructions for Form 10-Q and, therefore, do not include all disclosures required by accounting principles generally accepted in the United States of America for complete presentation of financial statements. In management's opinion, the consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial condition of Commercial National Financial Corporation as of September 30, 2004 and December 31, 2003 and the results of its operations for the three and nine months ending September 30, 2004 and September 30, 2003. The results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results expected for the full year. Principles of Consolidation The accompanying consolidated financial statements include the accounts of Commercial National Financial Corporation (CNFC), Commercial Bank (Bank), CNFC Financial Services, Inc. and CNFC Mortgage Corporation, both wholly owned subsidiaries of the Bank. All material intercompany accounts and transactions have been eliminated in consolidation. Nature of Operations, Industry Segments and Concentrations of Credit Risk CNFC is a one-bank holding company, which conducts limited business activities. The Bank performs the majority of business activities. The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. It maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit. While CNFC's chief decision-makers monitor the revenue stream of various products and services, operations are managed and financial performance is evaluated on a corporation-wide basis. Accordingly, management considers all of the CNFC's banking operations to be aggregated into one operating segment. The principal markets for the Bank's financial services are the Michigan communities in which the Bank is located and the areas surrounding these communities. The Bank serves these markets through nine offices located in Gratiot, Isabella and Montcalm Counties in Michigan. Use of Estimates To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. The allowance for loan losses and fair values of securities and other financial instruments are particularly subject to change. Stock Compensation Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. There were no grants for the period ending September 30, 2004. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation Expense. 7 COMMERCIAL NATIONAL FINANCIAL CORPORATION
Quarter to Date Year to Date September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003 ------------------ ------------------ ------------------ ----------------- Net income as reported $ 761,553 $ 818,436 $ 2,000,997 $ 1,586,950 Stock-based compensation expense (9,622) (34,860) (41,644) (88,221) ------------- ------------- ------------- ------------- Proforma net income/(loss) $ 751,931 $ 783,576 $ 1,959,353 $ 1,498,729 ============= ============= ============= ============= Basic earnings per share as reported $ .19 $ .20 $ .49 $ .39 Proforma basic earnings per share $ .18 $ .20 $ .48 $ .39 Diluted earnings per share as reported $ .19 $ .20 $ .49 $ .39 Proforma diluted earnings per share $ .18 $ .19 $ .48 $ .37
The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of the grant date. There were no grants for the period ending September 30, 2004.
Quarter to Date Year to Date September 30, 2003 September 30, 2003 ------------------ ------------------ Risk-free interest rate 3.57% 3.57% Expected option life 10.00 10.00 Expected stock price volatility 21.10 21.10 Dividend yield 4.31% 4.31%
Cash Flow Reporting Cash and cash equivalents include cash on hand, demand deposits with other financial institutions and federal funds sold. Cash flows are reported net for customer loan and deposit transactions, securities sold under agreements to repurchase with original maturity of 90 days or less and U.S. Treasury demand notes. Earnings and Dividends Per Share Basic earnings per common share is based on net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share shows the diluted effect of any additional potential common shares. Earnings and dividends per common share are restated for all stock splits and stock dividends. Comprehensive Income Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes the change in unrealized appreciation and depreciation on securities available for sale, net of tax, which is also recognized as a separate component of shareholders' equity. Reclassifications Some items in the prior year financial statements have been reclassified to conform with the current year presentation. Note 2 - Earnings Per Share A reconciliation of the numerators and denominators of the basic earnings per share and diluted earnings per share computations for the periods ended is presented below. Stock options representing 162,438 and 99,248 shares of common stock were not considered in computing diluted earnings per share for the three and nine month periods in 2003 and 2004 because they were antidilutive. 8 COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ended Nine Months Ended SEPTEMBER 30, September 30, SEPTEMBER 30, September 30, 2004 2003 2004 2003 ------------- ------------- ------------- ------------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $ 761,553 $ 818,436 $2,000,997 $1,586,950 Weighted-average common shares outstanding for basic earnings per share 4,083,126 4,025,517 4,080,976 4,025,517 ---------- ---------- ---------- ---------- BASIC EARNINGS PER SHARE $ .19 $ .20 $ .49 $ .39 ========== ========== ========== ========== DILUTED EARNINGS PER SHARE: Net income available to common shareholders $ 761,553 $ 818,436 $2,000,997 $1,586,950 Weighted-average common shares outstanding for basic earnings per share 4,083,126 4,025,517 4,080,976 4,025,517 Add: Dilutive effect of assumed exercise of stock options 32,399 44,432 38,670 44,432 ---------- ---------- ---------- ---------- Weighted-average common and dilutive additional potential common shares outstanding 4,115,525 4,069,949 4,119,646 4,069,949 ---------- ---------- ---------- ---------- DILUTED EARNINGS PER SHARE $ .19 $ .20 $ .49 $ .39 ========== ========== ========== ==========
9 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Summary Total assets ended the quarter at $243.8 million compared to $239.8 million at December 31, 2003. Management classifies the economic environment as having weak business loan demand offset by an active residential real estate market. The residential real estate refinancing activity has been significantly reduced as interest rates moved higher, however, the Bank has achieved some success in originating mortgages for home buyers. Loan totals increased $10.3 million primarily as a result of growth in the residential real estate loan portfolio. The business loan portfolio has decreased $4.2 million since December 31, 2003 while the residential real estate portfolio has increased $13.7 million. The increase in residential real estate loans was achieved through the origination of non-saleable mortgage loans and a decision by management to retain in portfolio up to 50% of saleable residential real estate loans. As discussed later, management closely monitors the interest rate risk exposure resulting from retaining greater levels of fixed rate assets. Liquidity Management defines liquidity as the ability to fund appropriate levels of credit worthy loans, meet the immediate cash withdrawal requirements of depositors, and maintain access to sufficient resources to meet unexpected contingencies at a reasonable cost, with minimal losses. Management believes that the combination of available FHLB advances, federal funds lines of credit, the available for sale investment portfolio, and our ability to sell mortgage loans provides adequate short and medium term sources of liquidity. At a minimum the Bank has the following available to meet short-term liquidity needs: $14.8 million in available FHLB advances based on available collateral and $9 million in short term federal funds lines of credit with correspondent banks and the Federal Reserve. In addition, CNFC has secured a $5 million line of credit with a correspondent bank. The stock of Commercial Bank secures the line of credit. The interest rate on the line of credit is equal to the prime interest rate at September 30, 2004 of 4.75%. CNFC also needs cash to pay dividends to its shareholders. The primary source of cash is the dividends paid to CNFC by the Bank. Management believes that cash from operations is sufficient to supply the cash needed to continue paying a reasonable dividend. Asset Quality At September 30, 2004 CNFC has identified $1.3 million of loans as non-accrual. This compares to $825,000 at December 31, 2003. All non-accrual loans are considered impaired. The specific allowance for loan loss allocated to non accrual loans is $442,000 at September 30, 2004 and $189,000 at December 31, 2003. The balance in repossessed assets and other real estate at September 30, 2004 represents one residential real estate property which management believes will not result in material loss. 10 COMMERCIAL NATIONAL FINANCIAL CORPORATION
September 30, 2004 December 31, 2003 ------------------ ----------------- Total loans $204,698,389 $194,389,682 Non-accrual loans $ 1,269,345 $ 825,129 Accruing loans past due 90 days or more 123,385 - Restructured Loans (non accrual) - - ------------ ------------ Total non-performing loans 1,392,730 825,129 Repossessed assets and other real estate 17,034 598,011 ------------ ------------ Total non-performing assets $ 1,409,764 $ 1,423,140 ============ ============ Total non-performing loans as a percentage of total loans .68% .42% ============ ============ Allowance for loan loss as a percentage of non-performing loans 174.99% 238.78% ============ ============ Total non-performing assets as a percentage of total assets .58% .59% ============ ============
Allowance for Loan Loss Summary of Activity
Nine Months Ended Year Ended Nine Months Ended September 30, 2004 December 31, 2003 September 30, 2003 ------------------ ----------------- ------------------ Beginning balance $ 1,970,309 $ 2,783,234 $ 2,783,234 Loan charge-offs (103,800) (3,120,283) (1,958,580) Loan recoveries 300,608 406,358 104,851 ------------- ------------- ------------- Net loan recoveries/(charge-offs) 196,808 (2,713,925) (1,853,729) Provision for loan losses 270,000 1,901,000 1,781,000 ------------- ------------- ------------- Ending balance $ 2,437,117 $ 1,970,309 $ 2,710,505 ============= ============= ============= Average loan balance $ 196,741,000 $ 184,693,000 $ 182,867,000 Net (charge-offs)/recoveries as a percentage of average loans 0.10% (1.47)% (1.01)% Allowance for loan loss as a percentage of total loans 1.19% 1.01% 1.44%
For purposes of evaluating the adequacy of the allowance, the performance of the loan portfolio is divided into four classifications: non-classified, watch, substandard-not impaired, and substandard-impaired. Management has subdivided the classifications of non-classified and watch into the following categories of loans: residential, consumer and business loans. Non-classified loans are loans that are viewed as homogeneous categories. These loans are generally current and performing as agreed. Commercial establishes a reserve on these categories of non-classified loans using the last three year historical charge-off experience. At September 30, 2004 $189.5 million or 92.6% of loan balances are considered to be non-classified. Watch credits are loans that management has identified as having some change that requires additional loan officer monitoring. These loans are generally paying as agreed, however, the ability to meet debt obligations, while adequate, has deteriorated. These loans are not considered impaired within the definition of FAS 114 and 118 and are viewed as homogeneous categories. At September 30, 2004 $9.0 million was classified as watch loans. Business loans represents $7.2 million or 80.0% of the watch loan balances. Seven-million or 97.2% of the watch business loans were current at September 30, 2004. 11 COMMERCIAL NATIONAL FINANCIAL CORPORATION Substandard-impaired and substandard-not impaired loans are business loans that management reviews for impairment under FAS 114 and 118. Management reviews these loans individually for impairment using either the present value of expected cash flow or the value of collateral. Loans not considered impaired are grouped as a homogenous category. A reserve is established on this category using historical loss experience. At September 30, 2004 substandard-not impaired balances totaled $1.8 million. All payments on loans in this category are current. A specific reserve is calculated for each loan identified as impaired, however, the total allowance is available for any loan. At September 30, 2004, $4.3 million was classified as substandard-impaired. Of the $4.3 million, $1.3 million is on non-accrual status, the remaining balances are less than 60 days past due. Total specific reserves allocated to those loans are $962,000 at September 30, 2004. Capital Resources CNFC's capital ratios continue to exceed regulatory guidelines for a "well capitalized" institution. It is management's intent to maintain capital ratios in excess of the minimum required to be well capitalized. A summary of CNFC's capital ratios follows:
Minimum Required to be Well Capitalized Under Minimum Required September 30, December 31, Prompt Corrective Action for Capital 2004 2003 Regulations Adequacy Purposes ------------- ------------ ------------------------ ----------------- Total capital to risk weighted assets 15.0% 14.4% 10.0% 8.0% Tier 1 capital to risk weighted assets 13.7% 13.3% 6.0% 4.0% Tier 1 capital to average assets 10.1% 10.2% 5.0% 4.0%
RESULTS OF OPERATIONS Summary Net income for the quarter ended September 30, 2004 was $762,000, a decrease of $56,000 compared to the same period in 2003. The primary factors that affected the decrease in net income are a $341,000 decrease in the provision for loan losses offset by a $166,000 decrease in gain on residential mortgage loan sales and $254,000 decrease in other income. Net income for the nine months ended September 30, 2004 was $2,001,000, an increase of $414,000 compared to the same period in 2003. The primary factors affecting the increase in net income are a $1,511,000 decrease in the provision for loan losses offset by a $693,000 decrease in non-interest income. Improving loan quality resulted in the decrease in the provision for loan losses. A $604,000 decrease in the net gain on sale of loans was the primary cause for the reduced non-interest income. Net Interest Income The following table illustrates the effect that changes in rates and balances of interest-earning assets and interest-bearing liabilities had on tax-equivalent net interest income for the three and nine months ending September 30, 2004 and 2003. 12 COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ending September 30, Nine Months Ending September 30, 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Interest income (tax equivalent) $ 3,647,399 $ 3,680,352 $ 10,465,506 $ 10,817,188 Interest expense 943,238 974,656 2,802,528 3,200,796 ------------ ------------ ------------ ------------ Net interest income $ 2,704,161 $ 2,705,696 $ 7,662,978 $ 7,616,392 ============ ============ ============ ============ Average balances Interest-earning assets $231,349,246 $221,588,374 $226,265,092 $225,288,866 Interest-bearing liabilities 195,724,084 188,077,797 193,035,283 193,547,969 ------------ ------------ ------------ ------------ Net differential $ 35,625,162 $ 33,510,577 $ 33,229,809 $ 31,740,897 ============ ============ ============ ============ Average Yields/Rates (annualized) Yield on earning assets 6.25% 6.59% 6.12% 6.46% Rate paid on liabilities 1.91% 2.06% 1.91% 2.23% ------------ ------------ ------------ ------------ Interest spread 4.34% 4.53% 4.21% 4.23% ============ ============ ============ ============ Net interest margin 4.64% 4.84% 4.48% 4.55% ============ ============ ============ ============
The following table quantifies the effect on net interest income of changes in the volume of assets and liabilities and the change in yields and cost of funds for the three and nine months ended September 30, 2004.
Three Months Ending Nine Months Ending September 30, 2004 September 30, 2004 Balance Rate Inc/(Dec) Balance Rate Inc/(Dec) -------- --------- -------- -------- --------- --------- Interest Earning Assets $213,239 $(246,192) $(32,953) $538,051 $(889,733) $(351,682) Interest Bearing Liabilities 95,530 126,948) (31,418) 157,666 (555,934) (398,268) -------- --------- -------- -------- --------- --------- Net Interest Income $117,709 $(119,244) $ (1,535) $380,385 $(333,799) $ 46,586 ======== ========= ======== ======== ========= =========
In general, interest rates have trended upward during the first nine months of 2004, as economic data supported a strengthening economy. The Federal Reserve Open Market Committee has increased the Federal Funds rate by 75 basis points since June 30, 2004. In the short run, margin increased from 4.45% for the quarter ending June 30, 2004 to 4.64% for the quarter ending September 30, 2004. The decrease in net interest income for the quarter ending September 30, 2004 compared to the same period in 2003 was primarily caused by a decrease in margin offset by an increase in average earning assets. The yield on earning assets continued to decrease, however, management was not able to lower funding costs accordingly. The factors affecting the $47,000 increase in tax equivalent net interest income for the nine months ending September 30, 2004 are similar to those described above for the three months ending September 30, 2004. The Bank experienced a decrease in margin offset by an increase in average earning assets. Noninterest Income Noninterest income for the three months ending September 30, 2004 was $342,000. This represents a $430,000 or 55.7% decrease over the same period in 2003. The decrease in the net gain on loan sales of $167,000 compared to the same period in 2003 contributed substantially to the overall decrease. Rising interest rates eliminated the incentive for residential real estate customers to refinance existing loans. Also, management has elected to portfolio up to 50% of the new loan originations that are saleable to the secondary market. 13 COMMERCIAL NATIONAL FINANCIAL CORPORATION Other non-interest income decreased $254,000 compared to the same period in 2003. During the third quarter of 2003, management recorded a gain on sale of other real estate of $250,000. The factors affecting the $693,000 decrease in noninterest income for the nine months ending September 30, 2004 are similar to those described above for the three months ending September 30, 2004, except for the following. Year to date other non-interest income decreased $72,000. As rates increased, the average life of the residential real estate mortgage loan portfolio has extended. This resulted in an increase in the value of mortgage servicing rights. During the second quarter of 2004, CNFC recorded a recovery of $132,000 in the value of mortgage servicing rights previously expensed to a valuation allowance. Noninterest Expense Noninterest expense for the three months ending September 30, 2004 totaled $1,797,000. This represents a $28,000 or 1.6% increase over the same period in 2003. Salary and benefit expense for the three months ending September 30, 2004 totaled $985,000 compared to $962,000 for the same period in 2003, an increase of $23,000 or 2.4%. The increase represents normal merit increases in salary, and normal increases in related benefit expense. Professional fees for the quarter ending September 30, 2004 totaled $91,000 compared to $118,000 for the same period in 2003. This represents a $27,000 or 22.9% decrease. Included in the 2003 totals was $18,000 in employment search fees. The search fees for 2004 are $0. The factors affecting the $247,000 increase in noninterest expense for the nine months ending September 30, 2004 are similar to those described above for the three months ending September 30, 2004. Further explanations are detailed below. Year to date occupancy expense increased $83,000 or 9.1% compared to the same period in 2003. The 2004 expense includes full year to date operating costs associated with our new Mt. Pleasant location. Year to date professional fees are $44,000 less than professional fees for the same period in 2003. During the nine months ended September 30, 2003 the Bank paid $43,000 in executive search fees. The Bank has spent $0 in search fees through September 30, 2004. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Commercial's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Commercial's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Also, Commercial has a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rate and commodity prices would have on interest rates are assumed to be insignificant. Interest rate risk (IRR) is the exposure of a banking organization's financial condition to movements in interest rates. Accepting this risk can be an important source of profitability and stockholder value; however, excessive levels of IRR could pose a threat to earnings and capital. Accordingly, effective risk management that maintains IRR at prudent levels is essential to Commercial's safety and soundness. Evaluating the quantitative level of IRR exposure requires the assessment of existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality. Commercial's Asset/Liability Committee ("Committee") is responsible for managing this process. Commercial derives the majority of income from the excess of interest collected over interest paid. The rates of interest earned on its assets and owed on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, Commercial is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. Commercial is also subject to repayment risk when interest rates fall. For example, mortgage loans and other financial assets may be prepaid by a debtor so that the debtor may refinance their obligations at lower rates. Prepayment of assets carrying higher rates reduces interest income and overall asset yields. 14 COMMERCIAL NATIONAL FINANCIAL CORPORATION Fluctuating interest rates and prepayment risk provide a challenge in managing the net interest income of the Bank. For example: the Bank may fund a 15 year fixed rate residential real estate loan with a long term amortizing Federal Home Loan Bank Advance. In a stable interest rate environment, the Bank can reasonably predict the net interest income earned. However, if rates fall significantly, the residential mortgage customer may refinance their mortgage at a lower rate. The Bank continues to pay the higher rate on the Federal Home Loan Bank advance, thus eroding net interest income. In an alternative scenario, the Bank funds the same 15 year fixed rate residential real estate loan with 1 year certificates of deposits. If rates rise at the end of one year, the Bank will pay more interest to continue to fund the residential mortgage loan with 1 year certificates of deposit. The net interest income will be lower in year two than it was in the first year of the mortgage loan. An additional challenge management faces in managing net interest income is the fact that what would maximize net interest income to the Bank may be in conflict with the customers' request for products and services. In the current low interest rate environment, management has greater concern that interest rates will rise significantly over time rather than fall. Management would prefer to offer variable rate loan products that would reprice upward as interest rates rise. However, our loan customers are generally requesting long term fixed rate loans. On the funding side, management would like to extend the maturities of its liabilities to match the loan customers' request for longer term fixed rate loans. However, our deposit customers' are reluctant to commit to long term certificates of deposits. Commercial's primary tool in measuring interest rate risk is to perform a simulation analysis. This analysis forecasts the effect of various interest rate changes on the cash flows associated with CNFC's assets and liabilities. One common scenario performed by the Committee is to "shock" the balance sheet by assuming that Commercial has just experienced an immediate and parallel shift in the yield curve up or down 200 basis points. The model, using data and assumptions determined by management, reprice assets and liabilities at new market rates. The objective of this testing is to determine how the Bank's net income and the economic value of equity are affected by extreme changes in interest rates. These results are recorded and compared to previous results. Management performs this calculation monthly. The limitation to this methodology is that the interest rate curve rarely shifts 200 basis points immediate and parallel. In addition, a downward 200 basis point shift in today's interest rate environment is not likely. Management implemented a new interest rate risk model during the first quarter of 2004. In addition to the 200 basis point immediate and parallel shift in interest rates, management performs additional projections using other interest rate environments, asset growth assumptions and funding strategies. The results listed below for December 31, 2003 were obtained using the Bank's prior model. The Table below summarizes the effect a 200 basis point immediate and parallel shift of the yield curve has on net income. In a falling interest rate environment, management does not have the ability to lower deposit rates 200 basis points to offset a decrease in rates on earning assets. Therefore, if rates decreased 200 basis points, margin would likely compress resulting in lower net interest income and potentially lower net income. A 200 basis point immediate and parallel decrease in interest rates is extremely unlikely. In an environment where interest rates increased 200 basis points in an immediate and parallel shift in the yield curve, management projects that net income will increase during the next 12 months. The difference in September 30, 2004 projected net income compared to December 31, 2003 is primarily due to the change in the interest rate risk model used by management. Management believes that the new model more accurately predicts the repricing opportunities and cash flows comprising the balance sheet at September 30, 2004.
Projected Percentage Change in Net Income September, 2004 December 31, 2003 --------------- ----------------- -200 basis points (16.0%) .3% 0 basis points 0.0 0.0 +200 basis points 3.6% (35.0%)
15 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures - Jeffrey S. Barker, the Corporation's Principal Executive Officer, and Patrick G. Duffy, the Corporation's Principal Financial Officer, have reviewed and evaluated the effectiveness of the Corporation's disclosure controls and procedures (as defined in Rules 240.13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")) as of the end of the period covered by this Form 10-Q quarterly report. Based on their evaluation, they have concluded that the Corporation's disclosure controls and procedures were effective as of September 30, 2004. (b) Changes in internal controls - The Corporation also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter that ended September 30, 2004. Forward Looking Statements This discussion and analysis of financial condition and results of operations, and other sections of this report contain forward looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about the Corporation itself. Words such as "anticipates", "believes", "estimates", "expects" "forecasts" "intends", "is likely", "plans", "product", "projects", variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward looking statements. Furthermore, CNFC undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events, or otherwise. Future Factors include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulations and tax laws; changes in prices, levies, and assessments; the impact of technology, governmental and regulatory policy changes; the outcome of pending and future litigation and contingencies; trends in customer behavior including their ability to repay loans; and vicissitudes of the national and local economies. These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement. PART II. OTHER INFORMATION ITEM 2 UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS The following table shows information relating to the repurchase of shares of Commercial National Financial Corporation common stock for the three months ended September 30, 2004:
Total Number Maximum of Shares Number Purchased as of Shares Part of Publicly That May Yet be Total Number Average Announced Purchased Under of Shares Price Paid Plans or the Plans or Purchased Per Share Programs(1) Programs(1) ------------ ---------- ---------------- --------------- July 1-31 10,018 11.25 10,018 61,888 August 1-31 304 11.25 304 61,584 September 1-30 - - - 61,584 ------ -------- ------ ------ Total 10,322 $ 11.25 10,322 61,584 ====== ======== ====== ======
---------- (1) A stock repurchase program was established during 1998. The board of directors of Commercial National Financial Corporation has authorized the repurchase of up to 383,340 shares. The repurchase program has no expiration date. 16 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 6 EXHIBITS Exhibits: Exhibit 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). Exhibit 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. 17 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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. Commercial National Financial Corporation (Registrant) Date: November 5, 2004 /s/ Jeffrey S. Barker ____________________________________________ Jeffrey S. Barker President and Chief Executive Officer Date: November 5, 2004 /s/ Patrick G. Duffy ____________________________________________ Patrick G. Duffy Executive Vice President and Chief Financial Officer 18 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- -------------------------------------------------------------------- 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer.
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