UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
| (Mark one) |
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the fiscal year ended: December 31, 2004 |
| OR |
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to |
Commission File Number 0-11244
GERMAN AMERICAN BANCORP
(Exact name of registrant as specified in its charter)
|
INDIANA (State or other jurisdiction of incorporation or organization) 711 Main Street, Box 810, Jasper, Indiana (Address of Principal Executive Offices) |
35-1547518 (I.R.S. Employer Identification No.) 47546 (Zip Code) |
Registrant's telephone number,
including area code: (812) 482-1314
Securities registered pursuant to Section 12 (b) of the Act: None
Securities registered pursuant to Section 12 (g) of the Act:
Common Shares, No Par Value
(Title of Class)
Preferred Stock Purchase Rights
(Title of Class)
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
NO
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
Regulation S-K (section 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES
NO
The aggregate market value of the registrant's common shares held by non-affiliates of the registrant, computed by reference to the price at which the common shares were last sold, as of June 30, 2004 (the last business day of the registrant's most recently completed second fiscal quarter) was approximately $157,030,000.
As of March 1, 2005, there were outstanding 10,900,948 common shares, no par value, of the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement of German American Bancorp for the Annual Meeting of its Shareholders to be held April 28, 2005, to the extent stated herein, are incorporated by reference into Part III.
GERMAN AMERICAN BANCORP
ANNUAL REPORT ON FORM 10-K
For Fiscal Year Ended December 31, 2004
Table of Contents
| PART I. | ||
| Item 1. | Business | 3 |
| Item 2. | Properties | 5 |
| Item 3. | Legal Proceedings | 5 |
| Item 4. | Submission of Matters to a Vote of Security Holders | 5 |
| PART II. | ||
| Item 5. | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
6 |
| Item 6. | Selected Financial Data | 7 |
| Item 7. | Management's Discussion and Analysis of Financial Condition and Results of Operations | 8-26 |
| Item 7A. | Quantitative and Qualitative Disclosures About Market Risk | 26-27 |
| Item 8. | Financial Statements and Supplementary Data | 28-58 |
| Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure | 59 |
| Item 9A. | Controls and Procedures | 59 |
| Item 9B. | Other Information | 59 |
| PART III. | ||
| Item 10. | Directors and Executive Officers of the Registrant | 59-60 |
| Item 11. | Executive Compensation | 60 |
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 60-61 |
| Item 13. | Certain Relationships and Related Transactions | 61 |
| Item 14. | Principal Accountant Fees and Services | 61 |
| PART IV. | ||
| Item 15. | Exhibits and Financial Statement Schedules | 62 |
| SIGNATURES | 63 | |
| INDEX OF EXHIBITS | 64-65 | |
2
Information included in or incorporated by reference in this Annual Report on Form 10-K, our other filing with the Securities and Exchange Commission (the “SEC”) and our press releases or other public statements, contain or may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to a discussion of our forward- looking statements and associated risks in “Item 1 – Forward-Looking Statements and Associated Risks” in this Annual Report on Form 10-K.
PART I
Item 1. Business.
General
German American Bancorp (“the Company”) is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s National Market System under the symbol GABC. The Company operates five affiliated community banks with 26 retail banking offices in the eight contiguous Southwestern Indiana counties of Daviess, Dubois, Gibson, Knox, Martin, Perry, Pike, and Spencer. The Company also operates a trust, brokerage and financial planning subsidiary, which operates from the banking offices of the bank subsidiaries, and two insurance agencies with five insurance agency offices throughout its market area. The Company’s lines of business include retail and commercial banking, mortgage banking, comprehensive financial planning, full service brokerage and trust administration, title insurance, and a full range of personal and corporate insurance products. Financial and other information by segment is included in Note 16 – Segment Information of the Notes to the Consolidated Financial Statements included in Item 8 of this Report and is incorporated into this Item 1 by reference. Substantially all of the Company’s revenues are derived from customers located in, and substantially all of its assets are located in, the United States.
The Company’s principal operating subsidiaries are described in the following table:
| Name |
Type of Business |
Principal Office Location |
|---|---|---|
| The German American Bank | Commercial Bank | Jasper, IN |
| First American Bank | Commercial Bank | Vincennes, IN |
| First Title Insurance Company | Title Insurance Agency | Vincennes, IN |
| First State Bank, Southwest Indiana | Commercial Bank | Tell City, IN |
| Peoples Bank | Commercial Bank | Washington, IN |
| Citizens State Bank | Commercial Bank | Petersburg, IN |
| German American Insurance, Inc. | Multi-Line Insurance Agency | Petersburg, IN |
| German American Financial Advisors & Trust Company | Trust, Brokerage, Financial Planning | Jasper, IN |
Competition
The industries in which the Company operates are highly competitive. The Company’s subsidiary banks compete for commercial and retail banking business within its core banking segment not only with financial institutions that have offices in the same counties but also with financial institutions that compete from other locations in Southwest Indiana and elsewhere. The Company’s subsidiaries compete with commercial banks, savings and loan associations, savings banks, credit unions, production credit associations, federal land banks, finance companies, credit card companies, personal loan companies, investment brokerage firms, insurance agencies, insurance companies, lease finance companies, money market funds, mortgage companies, and other non-depository financial intermediaries. Many of these banks and other organizations have substantially greater resources than the Corporation.
Employees
At March 1, 2005 the Company and its subsidiaries employed approximately 372 full-time equivalent employees. There are no collective bargaining agreements, and employee relations are considered to be good.
Regulation and Supervision
The Company is subject to the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is required to file with the Board of Governors of the Federal Reserve System (“FRB”) annual reports and such additional information as the FRB may require. The FRB may also make examinations or inspections of the Company. Under FRB policy, the Company is expected to act as a source of financial strength to its bank subsidiaries and to commit resources to support them even in circumstances where the Company might not do so absent such an FRB policy.
The Company’s five subsidiary banks are under the supervision of and subject to examination by the Indiana Department of Financial Institutions (“DFI”), and the Federal Deposit Insurance Corporation (“FDIC”). Regulation and examination by banking regulatory agencies are primarily for the benefit of depositors rather than shareholders.
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With certain exceptions, the BHC Act prohibits a bank holding company from engaging in (or acquiring direct or indirect control of more than 5 percent of the voting shares of any company engaged in) nonbanking activities. One of the principal exceptions to this prohibition is for activities deemed by the FRB to be “closely related to banking.” Under current regulations, bank holding companies and their subsidiaries are permitted to engage in such banking-related business ventures as consumer finance; equipment leasing; credit life insurance; computer service bureau and software operations; mortgage banking; and securities brokerage.
Under the BHC Act, certain well-managed and well-capitalized bank holding companies may elect to be treated as a “financial holding company” and, as a result, be permitted to engage in a broader range of activities that are “financial in nature” and in activities that are determined to be incidental or complementary to activities that are financial in nature. These activities include underwriting, dealing in and making a market in securities; insurance underwriting and agency activities; and merchant banking. Banks may also engage through financial subsidiaries in certain of the activities permitted for financial holding companies, subject to certain conditions. The Company has not elected to become a financial holding company and none of its subsidiary banks have elected to form financial subsidiaries.
The Company’s banks and their subsidiaries may generally engage in activities that are permissible activities for state chartered banks under Indiana banking law, without regard to the limitations that might apply to such activities under the BHC Act if the Company were to engage directly in such activities.
Indiana law and the BHC Act restrict certain types of expansion by the Company and its bank subsidiaries. The Company and its subsidiaries may be required to apply for prior approval from (or give prior notice and an opportunity for review to) the FRB, the DFI, and/or other bank regulatory or other regulatory agencies, as a condition to the acquisition or establishment of new offices, or the acquisition (by merger or consolidation, purchase or otherwise) of the stock, business or properties of other banks or other companies.
The earnings of commercial banks and their holding companies are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. In particular, the FRB regulates money and credit conditions and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. Government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for time and savings deposits. FRB monetary policies have had a significant effect on the operating results of commercial banks in the past and this is expected to continue in the future. The general effect, if any, of such policies upon the future business and earnings of the Company cannot accurately be predicted.
The Company and its bank subsidiaries are required by law to maintain minimum levels of capital. These required capital levels are expressed in terms of capital ratios, known as the leverage ratio and the capital to risk-based assets ratios. The Company significantly exceeds the minimum required capital levels for each measure of capital adequacy. See Note 9 to the Company’s consolidated financial statements that are presented in Item 8 of this report, which Note 9 is incorporated herein by reference.
Also, federal regulations define five categories of financial institutions for purposes of implementing prompt corrective action and supervisory enforcement requirements of the Federal Deposit Insurance Corporation Improvements Act of 1991. The category to which the most highly capitalized institutions are assigned is termed “well-capitalized.” Institutions falling into this category must have a total risk-based capital ratio (the ratio of total capital to risk-weighted assets) of at least 10%, a Tier 1 risk-based capital ratio (the ratio of Tier 1, or “core”, capital to risk-weighted assets) of at least 6%, a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 5%, and must not be subject to any written agreement, order or directive from its regulator relative to meeting and maintaining a specific capital level. On December 31, 2004, the Company had a total risk-based capital ratio of 11.83%, a Tier 1 risk-based capital ratio of 10.63% (based on Tier 1 capital of $78,945,000 and total risk-weighted assets of $742,323,000), and a leverage ratio of 8.50%. The Company and all its affiliate banks meet all of the requirements of the “well-capitalized” category and, accordingly, the Company does not expect these regulations to significantly impact operations.
The Company is a corporation separate and distinct from its bank and other subsidiaries. Most of the Company’s revenues will be received by it in the form of dividends, fees, and interest paid by its bank subsidiaries. These subsidiaries are subject to statutory restrictions on their ability to pay dividends. The FRB possesses enforcement powers over bank holding companies and their non-bank subsidiaries that enable it to prevent or remedy actions that in its view may represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability in appropriate cases to proscribe the payment of dividends by banks and bank holding companies. The FDIC and DFI possess similar enforcement powers over the respective bank subsidiaries of the Company for which they have supervision. The “prompt corrective action” provisions of federal banking law impose further restrictions on the payment of dividends by insured banks which fail to meet specified capital levels and, in some cases, their parent bank holding companies.
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Internet Address; Internet Availability of SEC Reports.
The Company’s Internet address is www.germanamericanbancorp.com.
The Company makes available, free of charge through the Investors section of its Internet website, its annual report on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after those reports are filed with or furnished to the Securities and Exchange Commission (SEC).
Forward-Looking Statements and Associated Risks
The Company from time to time in its oral and written communications makes statements relating to its expectations regarding the future. These types of statements are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements can include statements about the Company’s net interest income or net interest margin; adequacy of allowance for loan losses and the quality of the Company’s loans, investment securities and other assets; simulations of changes in interest rates; litigation results; dividend policy; estimated cost savings, plans and objectives for future operations; and expectations about the Company’s financial and business performance and other business matters as well as economic and market conditions and trends. They often can be identified by the use of words like “expect,” “may,” “will,” “would,” “could,” “should,” “intend,” “project,” “estimate,” “believe” or “anticipate,” or similar expressions.
The Company may include forward-looking statements in filings with the SEC, such as this Form 10-K, in other written materials, and in oral statements made by senior management to analysts, investors, representatives of the media, and others. It is intended that these forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the forward-looking statement is made.
Readers are cautioned that, by their nature, forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that are expressed or implied by any forward-looking statement. The discussion in Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” lists some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statements. Other risks, uncertainties, and factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statement include the unknown future direction of interest rates and the timing and magnitude of any changes in interest rates; the effects of changes in competitive conditions; acquisitions of other businesses by the Company and costs of integrations of such acquired businesses; the introduction, withdrawal, success and timing of business initiatives and strategies; changes in customer borrowing, repayment, investment and deposit practices; changes in fiscal, monetary and tax policies; changes in financial and capital markets; changes in general economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; the impact, extent and timing of technological changes; capital management activities; actions of the Federal Reserve Board and legislative and regulatory actions and reforms; changes in accounting principles and interpretations; the inherent uncertainties involved in litigation and regulatory proceedings which could result in the Company’s incurring loss or damage regardless of the merits of the Company’s claims or defenses; and the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends. Investors should consider these risks, uncertainties, and other factors in addition to those mentioned by the Company in its other SEC filings from time to time when considering any forward-looking statement.
Item 2. Properties.
The Company conducts its operations from the main office building of The German American Bank at 711 Main Street, Jasper, Indiana. The main office building contains approximately 23,600 square feet of office space. The Company’s subsidiaries conduct their operations from 30 other locations in Southwest Indiana.
Item 3. Legal Proceedings.
There are no material pending legal proceedings, other than routine litigation incidental to the business of the Company’s subsidiaries, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted during the fourth quarter of 2004 to a vote of security holders, by solicitation of proxies or otherwise.
5
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Market and Dividend Information
German American Bancorp’s stock is traded on NASDAQ’s National Market System under the symbol GABC. The quarterly high and low closing prices for the Company’s common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the table below. All per share data are retroactively restated for all stock dividends.
| 2004 | 2003 | ||||||
|---|---|---|---|---|---|---|---|
| High | Low | Cash Dividend |
High | Low | Cash Dividend | ||
| Fourth Quarter | $17.24 | $15.95 | $0.140 | $18.79 | $14.81 | $0.133 | |
| Third Quarter | $17.75 | $15.75 | $0.140 | $18.19 | $16.21 | $0.133 | |
| Second Quarter | $17.23 | $15.80 | $0.140 | $18.09 | $16.48 | $0.133 | |
| First Quarter | $18.02 | $16.81 | $0.140 | $18.55 | $16.91 | $0.133 | |
| $0.560 | $0.532 | ||||||
The Common Stock was held of record by approximately 3,803 shareholders at March 1, 2005.
Cash dividends paid to the Company’s shareholders are primarily funded from dividends received by the Company from its subsidiaries. The declaration and payment of future dividends will depend upon the earnings and financial condition of the Company and its subsidiaries, general economic conditions, compliance with regulatory requirements, and other factors.
| Transfer Agent: |
UMB Bank, N.A. Securities Transfer Division P.O. Box 410064 Kansas City, MO 64141-0064 Contact: Shareholder Relations (800) 884-4225 |
|
Shareholder Information and Corporate Office: |
Terri A. Eckerle German American Bancorp P. O. Box 810 Jasper, Indiana 47547-0810 (812) 482-1314 (800) 482-1314 |
Stock Repurchase Program Information
The following table sets forth information regarding the Company’s purchases of its common shares during each of the three months ended December 31, 2004.
| Period |
Total Number Of Shares (or Units) Purchased |
Average Price Paid Per Share (or Unit) |
Total Number of Shares (or Units) Purchases as Part of Publicly Announced Plans or Programs |
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) |
|---|---|---|---|---|
| October 2004 | --- | --- | --- | 355,789 |
| November 2004 | --- | --- | --- | 355,789 |
| December 2004 | --- | --- | --- | 355,789 |
(1) On April 26, 2001, the Company announced that its Board of Directors had approved a stock repurchase program for up to 607,754 of its outstanding common shares, of which the Company had purchased 251,965 common shares through December 31, 2004. The Board of Directors established no expiration date for this program.
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Item 6. Selected Financial Data.
The following selected data should be read in conjunction with the consolidated financial statements and related notes that are included in Item 8 of this report, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is included in Item 7 of this report (Dollars in thousands except per share data).
| 2004 |
2003 |
2002 |
2001 |
2000 | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Summary of Operations: | |||||||||||||||||
| Interest Income | $ | 47,710 | $ | 50,619 | $ | 60,494 | $ | 71,069 | $ | 79,319 | |||||||
| Interest Expense | 16,471 | 21,084 | 28,492 | 38,917 | 45,646 | ||||||||||||
| Net Interest Income | 31,239 | 29,535 | 32,002 | 32,152 | 33,673 | ||||||||||||
| Provision for Loan Losses | 2,015 | 811 | 1,115 | 660 | 2,231 | ||||||||||||
| Net Interest Income after Provision | |||||||||||||||||
| For Loan Losses | 29,224 | 28,724 | 30,887 | 31,492 | 31,442 | ||||||||||||
| Non-interest Income | 9,620 | (1) | 12,934 | 9,509 | 9,772 | 2,543 | (4) | ||||||||||
| Non-interest Expense | 30,609 | 32,219 | (2) | 28,967 | 29,308 | 28,238 | |||||||||||
| Income before Income Taxes | 8,235 | 9,439 | 11,429 | 11,956 | 5,747 | ||||||||||||
| Income Tax Expense | 996 | 1,271 | 1,987 | 2,763 | 459 | ||||||||||||
| Net Income | $ | 7,239 | $ | 8,168 | $ | 9,442 | $ | 9,193 | $ | 5,288 | |||||||
| Year-end Balances: | |||||||||||||||||
| Total Assets | $ | 942,094 | $ | 925,946 | $ | 957,005 | $ | 1,015,111 | $ | 1,079,808 | |||||||
| Total Loans, Net of Unearned Income | 629,793 | 611,866 | 610,741 | 657,166 | 709,744 | (4) | |||||||||||
| Total Deposits | 750,383 | 717,133 | 707,194 | 726,874 | 735,570 | ||||||||||||
| Total Long-term Debt | 69,941 | 76,880 | (2) | 121,687 | 156,726 | 182,370 | |||||||||||
| Total Shareholders' Equity | 83,669 | 83,126 | (3) | 104,519 | 102,209 | 97,260 | |||||||||||
| Average Balances: | |||||||||||||||||
| Total Assets | $ | 927,528 | $ | 938,992 | $ | 1,000,167 | $ | 1,014,917 | $ | 1,070,093 | |||||||
| Total Loans, Net of Unearned Income | 622,240 | 618,340 | 644,990 | 704,562 | 766,533 | (4) | |||||||||||
| Total Deposits | 731,467 | 711,310 | 718,763 | 718,160 | 749,235 | ||||||||||||
| Total Shareholders' Equity | 82,558 | 87,703 | (3) | 103,301 | 100,232 | 95,788 | |||||||||||
| Per Share Data(5): | |||||||||||||||||
| Net Income | $ | 0.66 | $ | 0.73 | (3) | $ | 0.79 | $ | 0.76 | $ | 0.44 | ||||||
| Cash Dividends | 0.56 | 0.53 | 0.51 | 0.48 | 0.45 | ||||||||||||
| Book Value at Year-end | 7.68 | 7.60 | (3) | 8.72 | 8.44 | 8.05 | |||||||||||
| Other Data at Year-end: | |||||||||||||||||
| Number of Shareholders | 3,219 | 3,198 | 3,299 | 3,314 | 3,208 | ||||||||||||
| Number of Employees | 372 | 383 | 390 | 422 | 405 | ||||||||||||
| Weighted Average Number of Shares(5) | 10,914,622 | 11,176,766 | (3) | 12,007,009 | 12,093,160 | 12,074,628 | |||||||||||
| Selected Performance Ratios: | |||||||||||||||||
| Return on Assets | 0.78 | % | 0.87 | % | 0.94 | % | 0.91 | % | 0.49 | % | |||||||
| Return on Equity | 8.77 | % | 9.31 | %(3) | 9.14 | % | 9.17 | % | 5.52 | % | |||||||
| Equity to Assets | 8.88 | % | 8.98 | %(3) | 10.92 | % | 10.07 | % | 9.01 | % | |||||||
| Dividend Payout | 84.46 | % | 73.26 | % | 64.99 | % | 63.98 | % | 98.54 | % | |||||||
| Net Charge-offs to Average Loans | 0.24 | % | 0.14 | % | 0.19 | % | 0.22 | % | 0.27 | % | |||||||
| Allowance for Loan Losses to Loans | 1.40 | % | 1.35 | % | 1.36 | % | 1.27 | % | 1.31 | % | |||||||
| Net Interest Margin | 3.86 | % | 3.61 | % | 3.67 | % | 3.61 | % | 3.57 | % | |||||||
| (1) |
In 2004, the Company recognized a $3.7 million non-cash pre-tax charge (which
reduced Non-interest Income) for the other-than-temporary decline in value of
its FHLMC and FNMA preferred stock portfolio. |
| (2) |
In 2003, the Company prepaid $40.0 million of FHLB borrowings within its
mortgage banking segment. The prepayment fees associated with the extinguishment
of these borrowings totaled $1.9 million. |
| (3) |
In March 2003, the Company purchased 1,110,444 (approximately 9% of the number
of shares that were then outstanding) of its common shares at $19.05 per share
pursuant to a self tender offer at a total cost, including fees and expenses
incurred in connection with the offer, of approximately $21.4
million. |
| (4) |
In 2000, the Company reclassified $69.8 million of sub-prime, out-of-market
residential mortgage loans as held-for-sale. The difference between book value
and market value resulted in a $5.2 million allowance for market loss on loans
held-for-sale. |
| (5) |
Share and Per Share Data has been retroactively adjusted to give effect for
stock dividends and excludes the dilutive effect of stock
options. |
7
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
INTRODUCTION
German American Bancorp (“the Company”) is a financial services holding company based in Jasper, Indiana. The Company’s Common Stock is traded on NASDAQ’s National Market System under the symbol GABC. The Company operates five affiliated community banks with 26 retail banking offices in the eight contiguous Southwestern Indiana counties of Daviess, Dubois, Gibson, Knox, Martin, Perry, Pike, and Spencer. The Company also operates a trust, brokerage and financial planning subsidiary which operates from the offices of the bank subsidiaries, and two insurance agencies with five agency offices throughout its market area. The Company’s lines of business include retail and commercial banking, mortgage banking, comprehensive financial planning, full service brokerage and trust administration, title insurance, and a full range of personal and corporate insurance products.
The information in this Management’s Discussion and Analysis is presented as an analysis of the major components of the Company’s operations for the years 2002 through 2004 and its financial condition as of December 31, 2004 and 2003. This information should be read in conjunction with the accompanying consolidated financial statements and footnotes contained elsewhere in this report, and with the description of business included in Item 1 of this Report (including the cautionary disclosure regarding “Forward Looking Statements and Associated Risks”). Financial and other information by segment is included in Note 16 – Segment Information of the Notes to the Consolidated Financial Statements included in Item 8 of this Report and is incorporated into this Item 7 by reference.
MANAGEMENT OVERVIEW
The Company’s performance in 2004 was overshadowed somewhat by the recording in the fourth quarter of 2004 a non-cash, other-than-temporary impairment charge of approximately $2.4 million after-tax, or $0.23 per share, related to certain investments in Federal Home Loan Mortgage Corporation (“FHLMC”) and Federal National Mortgage Association (“FNMA”) preferred stock. Public disclosures regarding accounting practices at FNMA and a multi-billion dollar FNMA preferred stock issuance with a substantially different structure and higher yield than previous offerings had a detrimental effect on the fair value of both the FHLMC and FNMA preferred stock holdings. As a result of these factors and the magnitude and length of time the market value had been below cost, management could not forecast full recovery of the fair values in a reasonable time period and concluded that the preferred stock was other than temporarily impaired. Accordingly, the other-than-temporary impairment was recognized in the income statement as an investment securities loss. The Company’s net income, inclusive of the impairment charge, for the year ended December 31, 2004, was $7,239,000, or $0.66 per share, compared with 2003 net income of $8,168,000, or $0.73 per share. Exclusive of the impairment charge, 2004 earnings would have been $9,669,000, or $0.89 per share.
As is the case for many banking organizations, the Company’s largest source of revenue has historically been, and continues to be, derived from the spread earned between its interest income and interest expense. As discussed in greater detail elsewhere in this discussion, improvements in the Company’s interest spread contributed to increased net interest income during 2004 compared to 2003. This improvement reversed a five-year trend of declines in net interest income.
In recent years, management has taken steps to enhance and grow its sources of non-interest-related revenue (such as insurance, trust administration, securities brokerage and financial planning) in an effort to reduce the Company’s dependency on its net interest income and net interest spread. The positive trends in growth in trust and investment product fees and in insurance revenues, (principally attributable to insurance acquisitions during 2003), continued in 2004. Management expects that these non-interest-related revenue sources will continue to significantly enhance its financial performance in the coming years.
The Company also has devoted increased emphasis in recent years to expanding its offering of loans and other products and services to business customers. Measured on an average basis, commercial/agricultural loans grew by approximately 10% in 2004, the seventh consecutive year of growth within this component of the Company’s balance sheet. The heightened management efforts to grow this component of the Company’ customer base is directly attributable to management’s belief that business customers, particularly small business customers, will value the Company’s approach of providing a combination of highly qualified professional financial advisors, local decision-making, and customer-focused products and services.
Management has continued to endeavor to improve the Company’s operating efficiency through enhanced employee productivity and the control of operating expenses, as evidenced by the three-year trend in the reduction in the number of full-time equivalent employees. The Company’s total operating expenses (exclusive of the 2003 net loss on extinguishment of borrowings) in 2004 increased modestly over those of 2003, mostly due to costs associated with compliance with requirements of Section 404 of the Sarbanes-Oxley Act.
In summary, management in 2005 expects to continue to reduce the Company’s reliance upon net interest income by increasing its emphasis on products and services that generate fees and commissions. Management also seeks to enhance the Company’s financial performance by increasing its offering of loans and other products and services to business customers, and operating more efficiently.
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The statements of management’s expectations and goals concerning the Company’s future operations and performance that are set forth in this Management Overview and in other sections of this Item 7 are forward-looking statements, and readers are cautioned that these forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that are expressed or implied by any forward-looking statement. The following discussion, as well as the discussion in Item 1 of this Form 10-K (“Business”) entitled “Forward-Looking Statements and Associated Risks” (which discussion is incorporated in this Item 7 by reference) lists some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any such forward-looking statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The financial condition and results of operations for German American Bancorp presented in the Consolidated Financial Statements, accompanying notes to the Consolidated Financial Statements, and selected financial data appearing elsewhere within this report, are, to a large degree, dependent upon the Company’s accounting policies. The selection of and application of these policies involve estimates, judgments and uncertainties that are subject to change. The critical accounting policies and estimates that the Company has determined to be the most susceptible to change in the near term relate to the determination of the allowance for loan losses, the valuation of mortgage servicing rights, the valuation of securities available for sale, and the valuation allowance on deferred tax assets and loss contingencies related to exposure from tax examinations.
Allowance for Loan Losses
The Company maintains an allowance for loan losses to cover probable incurred credit losses at the balance sheet date. 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. 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. A provision for loan losses is charged to operations based on management’s periodic evaluation of the necessary allowance balance. Evaluations are conducted at least quarterly and more often if deemed necessary. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.
The Company has an established process to determine the adequacy of the allowance for loan losses. The determination of the allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on other classified loans and pools of homogeneous loans, and consideration of past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors, all of which may be susceptible to significant change. The allowance consists of two components of allocations, specific and general. These two components represent the total allowance for loan losses deemed adequate to cover losses inherent in the loan portfolio.
Commercial, agricultural and poultry loans are subject to a standardized grading process administered by an internal loan review function. The need for specific reserves is considered for credits when graded substandard or special mention, or when: (a) the customer’s cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or, (d) other reasons where the ultimate collectibility of the loan is in question, or the loan characteristics require special monitoring. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that we believe indicates the loan is impaired. Specific allocations on impaired loans are determined by comparing the loan balance to the present value of expected cash flows or expected collateral proceeds. Allocations are also applied to categories of loans not considered individually impaired but for which the rate of loss is expected to be greater than historical averages, including those graded substandard or special mention and non-performing consumer or residential real estate loans. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values.
General allocations are made for other pools of loans, including non-classified loans, homogeneous portfolios of consumer and residential real estate loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a five-year historical average for loan losses for these portfolios, judgmentally adjusted for economic factors and portfolio trends.
Due to the imprecise nature of estimating the allowance for loan losses, the Company’s allowance for loan losses includes a minor unallocated component. The unallocated component of the allowance for loan losses incorporates the Company’s judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as economic uncertainties, lending staff quality, industry trends impacting specific portfolio segments, and broad portfolio quality trends. Therefore, the ratio of allocated to unallocated components within the total allowance may fluctuate from period to period.
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Mortgage Servicing Rights Valuation
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