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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES AND EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES AND 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 (I.R.S. Employer
incorporated or organization) Identification No.)
217 North Fourth Avenue., Sturgeon Bay, WI 54235
(Address of principal executive offices) (Zip Code)
Registrant's Telephone number, including area code: (920)-743-5551
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock $5 Par
Value
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K 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 |X| No
As of March 1, 2004, 7,621,976 shares of Common Stock were outstanding. As of
June 30, 2003, (the last business day of the Registrant's most recently
completed second fiscal quarter) the aggregate market value of the Common Stock
(based upon the $13.85 reported bid price on that date) held by non-affiliates
(excludes a total of 413,572 shares reported as beneficially owned by directors
and executive officers -- does not constitute an admission as to affiliate
status) was approximately $98,661,915.
DOCUMENTS INCORPORATED BY REFERENCE
Part of Form 10-K Into Which
Document Portions of Documents are Incorporated
- ----------------------------------- --------------------------------------
Definitive Proxy Statement for 2004 Part III
Annual Meeting of Shareholders to
be Filed within 120 days of the
fiscal Year ended December 31, 2003
1
2003 FORM 10-K
TABLE OF CONTENTS
DESCRIPTION PAGE NO.
----------- --------
PART I
ITEM 1. Business 3
ITEM 2. Properties 9
ITEM 3. Legal Proceedings 9
ITEM 4. Submission of Matters to a Vote of Security Holders 9
PART II
ITEM 5. Market for Registrant's Common Equity and Related
Stockholder Matters 9
ITEM 6. Selected Financial Data 10
ITEM 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 13
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk 47
ITEM 8. Financial Statements and Supplementary Data 48
ITEM 9. Changes and Disagreements with Accountants on Accounting and
Financial Disclosure. 89
PART III
ITEM 10. Directors and Executive Officers of the Registrant 89
ITEM 11. Executive Compensation 90
ITEM 12. Security Ownership of Certain Beneficial Owners and Management 90
ITEM 13. Certain Relationships and Related Transactions 91
PART IV
ITEM 14. Principal Accountant Fees and Services 91
PART V
ITEM 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 91
Signatures 92
2
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
The statements contained in this report, including the discussion and analysis
of financial condition and results of operations, that are not historical facts
are "forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 and are intended to be covered by the safe-harbor
provisions for forward-looking statements contained in that Act. For example,
all statements regarding our expected financial position, business and
strategies are forward-looking statements. The words "anticipates," "believes,"
"estimates," "seeks," "expects," "plans," "intends," and similar expressions, as
they relate to Baylake or its management, are intended to identify
forward-looking statements. Forward-looking statements are made based upon
management's current expectations and beliefs concerning future developments and
their potential effects upon Baylake or the Bank. Although we believe that the
expectations reflected in these forward-looking statements are reasonable, and
have based these expectations on our beliefs as well as assumptions we have
made, these expectations may prove to be incorrect. Actual results may differ
materially from those included in the forward-looking statements. Important
factors that could cause actual results to differ materially from our
expectations include, without limitation, the failure of a significant number of
borrowers to repay their loans (the level of non-performing loans), general
changes in economic conditions (including those related to tourism) and interest
rates, as well as restrictions imposed on us by regulations or regulators of the
banking industry. Many of these factors are not within the control of Baylake or
management. Baylake undertakes no obligation to update or revise any
forward-looking information, whether as a result of new information, future
developments or otherwise.
ITEM 1. BUSINESS
General
Baylake Corp., a Wisconsin corporation organized in 1976, ("Baylake" or the
"Company"), is a registered bank holding company under the Federal Bank Holding
Company Act of 1956, as amended. Baylake's primary activities consist of holding
indirectly the stock of Baylake Bank ("Bank"), and providing a wide range of
banking and related business activities, through the Bank and its other
subsidiaries. Baylake has elected to become a "financial holding company" under
the Gramm-Leach Bliley Act of 1999 ("GLB Act").
Baylake Bank
The Bank is a Wisconsin state bank originally chartered in 1876. The Bank
conducts its community banking business through 26 full-service financial
centers located throughout Northeast Wisconsin, in Brown, Door, Green Lake,
Kewaunee, Manitowoc, Outagamie, Waupaca, and Waushara Counties. The Bank has
eight financial centers in Door County, which is known for its seasonal and
tourism related services. The Bank has six financial centers in Brown County,
which includes the city of Green Bay and has a broader range of service,
manufacturing and retail job segments in its market. The balance of the Bank's
financial centers are located in the other previously mentioned counties. Other
principal industries in Bank's market area include light industry and
manufacturing, agriculture, food related products, and to a lesser degree,
lumber and furniture.
The Bank is an independent community bank offering a full range of financial
services primarily to small businesses and individuals located in its market
area. To complement the Bank's traditional banking products, such as demand
deposit accounts, various savings account plans, certificates of deposit and
real estate, consumer, commercial/industrial and agricultural loans, the Bank
offers its customers a variety of services. These services include transfer
agency, personal and corporate trust, insurance agency, brokerage, financial
planning, cash management and electronic banking services.
Subsidiaries
In addition to its banking operations, the Bank owns four non-bank subsidiaries:
Baylake Investments, Inc., located in Las Vegas, Nevada, which holds and manages
an investment and loan portfolio; Bank of Sturgeon Bay Building Corporation,
which owns the Bank's main office building in Sturgeon Bay, Wisconsin and nearby
conference center facilities and underlying real property; Cornerstone
Financial, Inc., which manages the conference center facilities; and Baylake
Insurance Agency, Inc., which offers various types of insurance products to the
general public as an independent
3
agent. The Bank also owns a minority interest (49.8% of the outstanding common
stock) in United Financial Services, Inc. ("UFS"), a data processing services
company, located in Grafton, Wisconsin, that provides data processing services
to approximately 23 banks (including the Bank) and ATM processing services to 50
banks. In February 2003, the Bank sold an additional subsidiary, Arborview LLC
("Arborview") which was formed for purposes of the operation of a community
based residential facility, acquired in lieu of foreclosure as a result of loan
problems.
At December 31, 2003, the Company had total assets of $975.2 million. For
additional financial information, see the Consolidated Financial Statements and
Notes beginning at Item 8 of this Form 10-K.
Corporate Governance Matters
Baylake maintains a website at www.baylake.com. The Company makes available
through that website, free of charge, copies of our Annual Reports on Form 10-K,
Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to
those reports, as soon as reasonably practical after Baylake electronically
files those materials with, or furnishes them to, the Securities and Exchange
Commission ("SEC"). The Company's SEC reports can be accessed through the
Baylake Corp link of our website. The SEC also maintains a website at
www.sec.gov that contains reports, proxy statements and other information
regarding SEC registrants.
Acquisitions
Effective November 21, 2003, Baylake acquired a branch facility from M&I
Marshall & Ilsley Bank, Milwaukee, Wisconsin ("M&I") located in Kewaunee, WI.
Approximately $9.5 million in deposits and $ 1.0 million in loans were acquired
as a result of the transaction. Costs to complete the purchase, including
premium on purchase, were $361,000 and were capitalized as a core deposit
intangible asset to be written off over seven years.
Lending
The Company offers short-term and long-term loans on a secured and unsecured
basis for business and personal purposes. It makes real estate,
commercial/industrial, agricultural and consumer loans, in accordance with the
basic lending policies established by its board of directors. The Company
focuses lending activities on individuals and small businesses in its market
area. Lending has, historically, been exclusively within the State of Wisconsin.
The Company does not conduct any substantial business with foreign obligors. The
markets served by the Company include a wide variety of industries, including a
limited concentration in tourism related industries, directly and indirectly.
Concentration in the restaurant and lodging business totaled $108.7 million in
loans at the end of 2003. Although competitive and economic pressures exist in
this segment, business remains strong in the markets served by the Company.
However, any general weakness in the economy of Northeastern Wisconsin (as a
result, for example, of a decline in its manufacturing and tourism industries or
otherwise) could have a material adverse effect on the business and operations
of Baylake.
The Company's total outstanding loans as of December 31, 2003 amounted to
approximately $696.0 million, consisting of 84.8% residential, commercial,
agricultural and construction real estate loans, 12.0% commercial and industrial
loans, 2.1% installment and 1.1% agricultural loans.
Investments
The Company maintains a portfolio of other investments, primarily consisting of
U.S. Treasury securities, U.S. Government Agency securities, mortgage-backed
securities, and obligations of states and their political subdivisions. The
Company attempts to balance its portfolio to manage interest rate risks,
maximize tax advantages and meet its liquidity needs while endeavoring to
maximize investment income.
Deposits
The Company offers a broad range of depository products, including non-interest
bearing demand deposits,
4
interest-bearing demand deposits, various savings and money market accounts and
certificates of deposit. Deposits at the Company are insured by the Bank
Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC") up to
statutory limits. At December 31, 2003, the Company's total deposits amounted to
$783.3 million, including interest bearing deposits of $676.7 million and
non-interest bearing deposits of $106.6 million.
Other Customer Services and Products
Other services and products offered by the Company include transfer agency, safe
deposit box services, personal and corporate trust services, conference center
facilities, insurance agency and brokerage services, cash management, financial
planning and electronic banking services, including eBanc, an Internet banking
product for its customers.
Seasonality
The tourism industry serviced in the market areas served, particularly the Door
County market, remains important with respect to the commercial and retail lines
doing business with the Company. The tourist business of the Door County is
seasonal, with the season beginning in early spring and continuing until late
fall. The seasonal nature of the tourist business imposes increased demands for
loans shortly before and during the tourist season and causes reduced deposits
shortly before and during the early part of the tourist season, although the
financial needs of those involved in the delivery of tourist related services is
a year around concern.
The Company's expansion into other market areas has reduced the concentration
level of tourism-related business, but these types of businesses still remain an
important element of the core business served by the Company.
Competition
The financial services industry is highly competitive. The Company competes with
other financial institutions and businesses in both attracting and retaining
deposits and making loans in all of its principal markets. The primary factors
in competing for deposits are interest rates, personalized services, the quality
and range of financial services, convenience of office locations and office
hours. Competition for deposit products comes primarily from other commercial
banks, savings banks, credit unions and non-bank competitors, including
insurance companies, money market and mutual funds, and other investment
alternatives. The primary factors in competing for loans are interest rates,
loan origination fees, the quality and range of lending services and
personalized services. Competition for loans comes primarily from other
commercial banks, savings banks, mortgage banking firms, credit unions, finance
companies, leasing companies, and other financial intermediaries. The Company
also faces direct competition from members of bank holding company systems that
have greater assets and resources than those of the Company.
Regulation and Supervision
The banking industry is highly regulated by both federal and state regulatory
authorities. Regulation includes, among other things, capital and reserve
requirements, dividend limitations, limitations on products and services
offered, geographical limits, consumer credit regulations, community
reinvestment requirements and restrictions on transactions with affiliated
parties. The system of supervision and regulation applicable to Baylake and the
Bank establishes a comprehensive framework for our respective operations and is
intended primarily for the protection of the FDIC's deposit funds, the
depositors of the Bank and the public, rather than shareholders of the Bank or
Baylake. Any change in government regulation may have a material adverse effect
on the business of Baylake and the Bank.
Baylake Corp. As a financial holding company, Baylake is subject to regulation
by the Federal Reserve Board under the Bank Holding Company Act of 1956, as
amended, or BHCA. Under the BHCA, Baylake is subject to examination by the
Federal Reserve Board and is required to file reports of its operations and such
additional information as the Federal Reserve Board may require. Baylake is also
subject to supervision and examination by the Wisconsin Department of Financial
Institutions under Wisconsin law. Under Federal Reserve Board policy, Baylake is
expected to act as a source of financial strength to the Bank and to commit
resources to support the Bank in circumstances where Baylake might not do so
absent such policy.
5
Any loans by a bank holding company to a subsidiary bank are subordinate in
right of payment to deposits and to certain other indebtedness of such
subsidiary bank. In the event of a bank holding company's bankruptcy, any
commitment by the bank holding company to a federal bank regulatory agency to
maintain the capital of a subsidiary bank will be assumed by the bankruptcy
trustee and entitled to a priority of payment.
With certain limited exceptions, the BHCA prohibits bank holding companies from
acquiring direct or indirect ownership or control of voting shares or assets of
any company other than a bank, unless the company involved is engaged solely in
one or more activities which the Federal Reserve Board has determined to be
financial in nature, and the extent to which state laws will apply to managing
or controlling activities of banks as to be incidental to these operations.
The Federal Reserve Board uses capital adequacy guidelines in its examination
and regulation of bank holding companies. If capital falls below minimum
guidelines, a bank holding company may, among other things, be denied approval
to acquire or establish banks or non-bank businesses.
Baylake Bank. As a Federal Reserve Board member Wisconsin bank, the Bank is
subject to supervision and regulation by the Wisconsin Department of Financial
Institutions (the "WDFI"), the Board of Governors of the Federal Reserve System
and the FDIC. Federal law and regulations establish supervisory standards
applicable to the lending activities of the Bank, including internal controls,
credit underwriting, loan documentation and loan-to-value ratios for loans
secured by real property.
The Bank is subject to federal and state statutory and regulatory restrictions
on any extension of credit to Baylake or its subsidiaries, on investments in the
stock or other securities of Baylake or its subsidiaries, on the payment of
dividends to Baylake, and on the acceptance of the stock or other securities of
Baylake or its subsidiaries as collateral for loans to any person. Limitations
and reporting requirements are also placed on extension of credit by the Bank to
its directors and officers, to directors and officers of us and our
subsidiaries, to principal shareholders of us, and to "related interests" of
such directors, officers and principal shareholders. In addition, such
legislation and regulations may affect the terms upon which any person becoming
a director or officer of us or one of our subsidiaries or a principal
shareholder of us may obtain credit from banks with which we maintain a
correspondent relationship.
The FDIC and the Federal Reserve Board have published guidelines establishing
operational and managerial standards to promote the safety and soundness of
federally insured depository institutions. The guidelines establish standards
for internal controls, information systems, internal audit systems, loan
documentation, credit underwriting, interest rate exposure, asset growth, and
compensation, fees and benefits. In general, the guidelines prescribe the goals
to be achieved in each area, and each institution will be responsible for
establishing its own procedures to achieve those goals. If an institution fails
to comply with any of the standards set forth in the guidelines, the
institution's primary federal bank regulator may require the institution to
submit a plan for achieving and maintaining compliance. The preamble to the
guidelines states that the agencies expect to require a compliance plan from an
institution whose failure to meet one or more of the standards is of such
severity that it could threaten the safe and sound operation of the institution.
Failure to submit an acceptable compliance plan, or failure to adhere to a
compliance plan that has been accepted by the appropriate regulator, would
constitute grounds for further enforcement action.
The Bank's business includes making a variety of types of loans to individuals.
In making these loans, the Bank is subject to state usury and regulatory laws
and to various federal statutes, such as the Equal Credit Opportunity Act, the
Fair Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement
Procedures Act and the Home Mortgage Disclosure Act, and the regulations
promulgated thereunder, which prohibit discrimination, specify disclosures to be
made to borrowers regarding credit and settlement costs and regulate the
mortgage loan servicing activities of the Bank, including the maintenance and
operation of escrow accounts and the transfer of mortgage loan servicing. The
Riegle Act imposed new escrow requirements on depository and non-depository
mortgage lenders and services under the National Flood Insurance Program. In
receiving deposits, the Bank is subject to extensive regulation under state and
federal law and regulations, including the Truth in Savings Act, the Expedited
Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer Act,
and the Federal Deposit Insurance Act. Violation of these laws could result in
the imposition of significant damages and fines upon the Bank, its directors and
officers.
6
Under the Community Reinvestment Act, or CRA, and the implementing regulations,
the Bank has a continuing and affirmative obligation to help meet the credit
needs of its local community including low and moderate-income neighborhoods,
consistent with the safe and sound operation of the institution. The CRA
requires the board of directors of financial institutions, such as the Bank, to
adopt a CRA statement for each assessment area that, among other things,
describes its efforts to help meet community credit needs and the specific types
of credit that the institution is willing to extend. The Bank's service area is
designated and comprised of the eight counties within the geographic area of
Central and Northeast, Wisconsin. The Bank's board of directors is required to
review the appropriateness of this delineation at least annually.
Financial institution regulation has been the subject of significant legislation
in recent years and may be the subject of further significant legislation in the
future. This regulation substantially affects the business and financial results
of all financial institutions and holding companies, including Baylake and its
subsidiaries. As an example, Baylake is subject to the capital and leverage
guidelines of the Board of Governors of the Federal Reserve System ("FRB"),
which requires that Baylake's capital to asset ratio meet certain minimum
standards. For a discussion of the Federal Reserve Board's guidelines and the
Company's applicable ratios, see the section entitled "Capital Resources" under
Item 7: "Management's Discussion and Analysis of Financial Condition and Results
of Operation."
The Federal Reserve adopted a new regulation, Regulation W, effective April 1,
2003, that comprehensively implements sections 23A and 23B. The regulation
unifies and updates staff interpretations issued over the years, incorporates
several new interpretative proposals (such as to clarify when transactions with
an unrelated third party will be attributed to an affiliate), and addresses new
issues arising as a result of the expanded scope of nonbanking activities
engaged in by banks and bank holding companies in recent years and authorized
for financial holding companies under the GLB Act.
Under the GLB Act, all financial institutions, including the Company and the
Bank, are required to adopt privacy policies, restrict the sharing of nonpublic
customer data with nonaffiliated parties at the customer's request, and
establish procedures and practices to protect customer data from unauthorized
access. The Company has developed such policies and procedures for itself and
the Bank, and believes it is in compliance with all privacy provisions of the
GLB Act.
On December 4, 2003, the Fair and Accurate Credit Transactions Act of 2003
("FACT") was signed into law. The Act includes many provisions concerning
national credit reporting standards, and permits consumers, including the
customers of the Company and the Bank, to opt out of information sharing among
affiliated companies for marketing purposes. The Act also requires financial
institutions, including banks, to opt out of information sharing among
affiliated companies for marketing purposes. FACT also requires financial
institutions, including banks, to notify their customers if they report negative
information about them to credit bureaus or if the credit that is granted to
them is on less favorable terms than are generally available. Banks must also
comply with guidelines to be established by their federal banking regulators to
help detect identity theft.
Under Title III of the USA PATRIOT Act ("PATRIOT"), also known as the
International Money Laundering Abatement and Anti-Terrorism Financing Act of
2001, all financial institutions, including the Company and Bank, are required
to take certain measures to identify customers, prevent money laundering,
monitor certain customer transactions and report suspicious activity to U.S. law
enforcement agencies, and scrutinize or prohibit altogether certain transactions
of special concern. Financial institutions are also required to respond to
requests for information from federal banking regulatory agencies and law
enforcement agencies concerning their customers and their transactions.
Information sharing among financial institutions concerning terrorist or money
laundering activities is encouraged by an exemption provided from the privacy
provisions of GLB Act and other laws. The effectiveness of a financial
institution in combating money laundering activities is a factor to be
considered in any application submitted by the financial institution under the
Bank Merger Act, which applies to Bank, or the BHC Act, which applies to
Company. The Company has in place a Bank Secrecy Act compliance program, and it
engages in very few transactions of any kind with foreign financial institutions
or foreign persons.
The Sarbanes-Oxley Act of 2002 ("SOA"), addresses, among other issues, director
and officer responsibilities for proper corporate governance of publicly traded
companies, including the establishment of audit committees, certification of
7
financial statements, auditor independence and accounting standards, executive
compensation, insider loans, whistleblower protection, and enhanced and timely
disclosure of corporate information. In general, SOA is intended to allow
stockholders to monitor more effectively the performance of publicly traded
companies and their management. The Securities and Exchange Commission has
enacted rules to implement various provisions of SOA. The federal banking
regulators have adopted generally similar requirements concerning the
certification of financial statements.
In addition to general requirements that banks retain specified levels of
capital and otherwise conduct their business in a safe and sound manner,
Wisconsin law requires that dividends of Wisconsin banks declared and paid
without approval of the WDFI be paid out of current earnings or, no more than
once within the immediate preceding two years, out of undivided profits in the
event that there have been insufficient net profits. Any other dividends require
the prior written consent of the WDFI. The Bank is in compliance with all
applicable capital requirements and may pay dividends to Baylake.
Current federal law provides that adequately managed bank holding companies from
any state may acquire banks and bank holding companies located in any other
state, subject to certain conditions. Wisconsin law generally permits
establishment of full service bank branch offices statewide.
Employees
At December 31, 2003, Baylake and its subsidiaries had 302 full-time equivalent
employees. Baylake considers the relationship with its employees to be good.
8
ITEM 2. PROPERTIES
Baylake does not directly own any real property of any kind. However, the Bank
owns twenty-three branches and leases the Company's main office building in
Sturgeon Bay, Wisconsin from its subsidiary, the Bank of Sturgeon Bay Building
Corporation. The Bank leases its remaining two offices from third parties.
The main office building located in Sturgeon Bay serves as headquarters for
Baylake as well as the main banking office of the Bank. The main office also
accommodates the expanded business of the Bank, primarily an insurance agency
(Baylake Insurance Agency) and financial services. The twenty-six branches owned
or leased by the Bank are in good condition and considered adequate for present
and near term requirements. In addition, the Bank owns other real property that,
when considered in the aggregate, is not material to its financial position.
ITEM 3. 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth
quarter of fiscal year 2003.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER
MATTERS
Historically, trading in shares of the Company's Common Stock has been limited.
Since mid-1993, Baylake Common Stock has been listed on the OTC Bulletin Board
(Trading symbol: bylk.ob), an electronic interdealer quotation system providing
real-time quotations on eligible securities. Trading in Baylake Common Stock has
been conducted principally by certain brokerage and investment firms with
offices in Door County, Wisconsin that have provided price quotations, and have
assisted individual holders of Baylake Common Stock who wish to purchase or sell
shares. In addition, prices for Baylake Common Stock are reported regularly in
The Milwaukee Journal Sentinel based on information provided by a local
brokerage firm.
The following table summarizes high and low bid prices and cash dividends paid
for the Baylake Common Stock for the periods indicated. Bid prices are as
reported from the OTC Bulletin Board. The reported high and low prices represent
interdealer bid prices, without retail mark-up, mark-downs or commission, and
may not necessarily represent actual transactions.
Cash dividends per
Calendar period High Low share
--------------- ------- ------- ------------------
2002 1st Quarter $ 14.00 $ 12.95 $ 0.12
2nd Quarter $ 13.40 $ 12.75 $ 0.12
3rd Quarter $ 13.90 $ 13.05 $ 0.12
4th Quarter $ 13.60 $ 13.30 $ 0.13
2003 1st Quarter $ 14.00 $ 13.30 $ 0.13
2nd Quarter $ 15.00 $ 13.10 $ 0.13
3rd Quarter $ 15.00 $ 13.50 $ 0.13
4th Quarter $ 14.89 $ 13.80 $ 0.14
9
Baylake had approximately 1,838 shareholders of record at December 31, 2003. The
number of shareholders does not reflect persons or entities that hold their
stock in nominee or "street" name through various brokerage firms.
Dividends on Baylake Common Stock have historically been paid in cash on a
quarterly basis in March, June, September and January, and Baylake expects to
continue this practice for the immediate future. The holders of Baylake Common
Stock are entitled to receive such dividends when and as declared by Baylake's
Board of Directors. In determining the payment of cash dividends, the Board of
Directors of Baylake considers the earnings, capital and debt servicing
requirements, financial ratio guidelines issued by the FRB and other banking
regulators, financial conditions of Baylake and the Bank, and other relevant
factors.
The ability of Baylake to pay dividends is dependent upon receipt by Baylake of
dividends from the Bank, which is subject to regulatory restrictions. Such
restrictions, which govern state chartered banks, generally limit the payment of
dividends on bank stock to the Bank's undivided profits after all payments of
all necessary expenses, provided that the Bank's surplus equals or exceeds its
capital, as discussed further in Item 7. "Management Discussion and Analysis of
Financial Condition and Results of Operation-Capital Resources". In addition,
under the terms of Baylake's 10.00% Junior Subordinated Debentures due 2031,
Baylake would be precluded from paying dividends on the Common Stock if it was
in default under the Debentures, if it exercised its right to defer payments of
interest on the Debentures, or if certain related defaults occurred.
Baylake maintains a dividend reinvestment plan enabling participating
shareholders to elect to purchase shares of Baylake Common Stock in lieu of
receiving cash dividends. Such shares may be newly issued securities or acquired
in the market and will be purchased on behalf of participating shareholders at
their then fair market value.
ITEM 6. SELECTED FINANCIAL DATA
BAYLAKE CORP.
FIVE YEAR SELECTED FINANCIAL DATA
Year Ended December 31,
-------------------------------------------------------------------
2003 2002 2001 2000 1999
---------- ---------- ---------- ---------- ----------
(dollars in thousands, except per share data)
RESULTS OF OPERATIONS:
Interest income $ 47,474 $ 51,564 $ 59,023 $ 56,036 $ 46,467
Interest expense 18,466 22,188 32,053 32,099 23,280
---------- ---------- ---------- ---------- ----------
Net interest income 29,008 29,376 26,970 23,937 23,187
Provision for loan losses 5,650 5,700 2,880 545 850
---------- ---------- ---------- ---------- ----------
Net interest income after
provision for loan losses 23,358 23,676 24,090 23,392 22,337
Non-interest income:
Gain on sale of loans 1,910 1,425 873 240 295
Loan servicing fees 2,009 1,587 1,665 938 981
Trust fees 677 637 664 517 553
10
Service charges on deposit
accounts 2,857 2,853 1,836 1,489 1,369
Securities gains (losses), net 0 509 0 0 (2)
Other 3,238 4,002 1,473 1,603 1,466
---------- ---------- ---------- ---------- ----------
Total non-interest income 10,691 11,013 6,511 4,787 4,662
Non-interest expense
Salaries and employee
benefits 14,183 13,743 11,923 10,353 9,700
Occupancy expense, net 3,525 3,585 3,235 3,047 2,668
Data processing 1,087 1,040 986 932 872
Other non-interest expense 4,859 4,820 4,583 4,381 4.353
Operation of other real estate 378 203 248 (22) (117)
---------- ---------- ---------- ---------- ----------
Total non-interest expense 24,032 23,391 20,975 18,691 17,476
---------- ---------- ---------- ---------- ----------
Income before income tax 10,017 11,298 9,626 9,488 9,523
Income tax provision 2,060 2,575 2,091 2,778 2,600
---------- ---------- ---------- ---------- ----------
Net income $ 7,957 $ 8,723 $ 7,535 $ 6,710 $ 6,923
PER SHARE DATA: (1)
Net income per share (basic) $ 1.06 $ 1.17 $ 1.01 $ 0.90 $ 0.94
Net income per share
(diluted) 1.04 1.15 0.99 0.87 0.90
Cash dividends per common
share 0.53 0.49 0.45 0.41 0.37
Book value per share 9.16 8.74 7.91 7.14 6.21
SELECTED FINANCIAL
CONDITION DATA (AT END OF
PERIOD):
Total assets $ 975,238 $ 904,656 $ 845,713 $ 772,268 $ 646,310
Investment securities (2) 195,847 151,366 167,100 153,511 145,080
Total loans 696,155 665,887 607,715 555,831 447,767
Total deposits 783,292 740,324 669,812 554,005 504,074
Short-term borrowings (3) 23,359 10,056 2,837 79,538 9,231
Other borrowings (4) 75,092 65,000 90,000 77,700 80,000
Notes payable and
subordinated debt 53 106 158 211 264
Trust preferred securities 16,598 16,100 16,100 0 0
Total shareholders' equity 69,628 65,400 59,130 53,127 46,210
PERFORMANCE RATIOS:
Return on average assets 0.87% 1.00% 0.93% 0.95% 1.12%
Return on average total
shareholders' equity 11.86% 13.82% 13.37% 13.76% 15.07%
Net interest margin (5) 3.60% 3.87% 3.79% 3.88% 4.35%
Net interest spread (5) 3.35% 3.61% 3.34% 3.37% 3.89%
Non-interest income to
average assets 1.17% 1.26% 0.78% 0.66% 0.74%
Non-interest expense to
average assets 2.63% 2.68% 2.57% 2.63% 2.82%
Net overhead ratio (6) 1.46% 1.42% 1.79% 1.97% 2.08%
Average loan-to-average
deposit ratio 90.64% 91.80% 95.76% 96.71% 85.54%
Average interest-earning
assets to average interest-
bearing liabilities 111.54% 109.55% 110.33% 110.78% 111.14%
11
ASSET QUALITY RATIOS: (7)
Non-performing loans to
total loans 2.33% 3.32% 2.42% 2.34% 2.80%
Allowance for loan losses to:
Total loans 1.75% 1.71% 1.32% 1.26% 1.70%
Non-performing loans 74.95% 51.66% 54.47% 53.94% 60.67%
Net charge-offs to average
loans 0.72% 0.36% 0.32% 0.23% 0.80%
Non-performing assets to
total assets 1.90% 2.76% 1.93% 1.80% 1.95%
CAPITAL RATIOS: (8)
Shareholders' equity to assets 7.14% 7.23% 6.99% 6.88% 7.15%
Tier 1 risk-based capital 9.52% 9.74% 10.10% 7.77% 8.81%
Total risk-based capital 10.78% 10.99% 11.29% 8.92% 10.07%
Leverage ratio 8.38% 8.24% 8.22% 6.38% 6.79%
RATIO OF EARNINGS TO FIXED
CHARGES: (9)
Including deposit interest 1.54x 1.51x 1.30x 1.30x 1.41x
Excluding deposit interest 3.62x 3.33x 2.27x 2.11x 3.55x
(1) Earnings and dividends per share are based on the weighted average number
of shares outstanding for the period.
(2) Includes securities classified as held-to-maturity and available for sale.
(3) Consists of Federal Home Loan Bank advances, federal funds purchased and
collateralized borrowings.
(4) Consists of Federal Home Loan Bank term notes and Company borrowings from
unaffiliated correspondent bank.
(5) Net interest margin represents net interest income as a percentage of
average interest-earning assets, and net interest rate spread represents
the difference between the weighted average yield on interest-earning
assets and the weighted average cost of interest-bearing liabilities.
(6) Net overhead ratio represents the difference between noninterest expense
and noninterest income, divided by average assets.
(7) Non-performing loans consist of non-accrual loans, guaranteed loans 90
days or more past due but still accruing interest and restructured loans.
(8) The capital ratios are presented on a consolidated basis. For information
on Baylake and the Bank's regulatory capital requirements, see Item 7.
"Management's Discussion and Analysis of Financial Condition and Results
of Operations-Capital Resources" and Item 1. "Business-Regulation and
Supervision".
(9) For purposes of calculating the ratio of earnings to fixed charges,
earnings consist of income before taxes plus interest and rent expense.
Fixed charges consist of interest and rent expense.
12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
General
The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of the Baylake Corp.
("Baylake" or the "Company"), which may not be otherwise apparent from the
consolidated financial statements included in this report at Item 8. This
discussion and analysis should be read in conjunction with those financial
statements, related notes, the selected financial data and the statistical
information presented elsewhere in this report for a more complete understanding
of the following discussion and analysis.
Critical Accounting Policies
In the course of the Company's normal business activity, management must select
and apply many accounting policies and methodologies that lead to the financial
results presented in the consolidated financial statements of the Company. Some
of these policies are more critical than others.
Allowance for Loan Losses: Management considers the accounting policy relating
to the allowance for loan losses to be a critical accounting policy because of
the uncertainty and subjectivity inherent in estimating the levels of allowance
needed to cover probable credit losses within the loan portfolio and the
material effect that these estimates can have on the Company's results of
operations. While management's evaluation of the allowance for loan losses as of
December 31, 2003 considers the allowance to be adequate, under adversely
different conditions or assumptions, the Company would need to increase the
allowance. In addition, the assumptions and estimates used in the internal
reviews of the Company's non-performing loans and potential problem loans, as
well as the associated evaluation of the related collateral coverage for these
loans, has a significant impact on the overall analysis of the adequacy of the
allowance for loan losses. Though management has concluded that the current
evaluation of collateral values is reasonable under the circumstances, if
collateral evaluation were significantly lowered, the Company's allowance for
loan losses policy would also require making additional provisions for loan
losses.
Management reviews the adequacy of the Allowance for Loan Losses ("allowance" or
"ALL") on a quarterly basis to determine whether, in management's estimate, the
allowance is adequate to provide for possible losses inherent in the loan
portfolio as of the balance sheet date. Management's evaluation of the adequacy
of the ALL is based primarily on management's periodic assessment and grading of
the loan portfolio as described below. Additional factors considered by
management include the consideration of past loan loss experience, trends in
past due and non-performing loans, risk characteristics of the various
classifications of loans, current economic conditions, the fair value of
underlying collateral, and other regulatory or legal issues that could affect
credit losses.
Loans are initially graded when originated. They are re-graded as they are
renewed, when there is a loan to the same borrower, when identified facts
demonstrate heightened risk of nonpayment, or if they become delinquent. The
loan review, or, grading process attempts to identify and measure problem and
watch list loans. Problem loans are those loans that management determines have
a higher than average risk for default, with workout and/or legal action
probable within one year. These loans are reported at least quarterly to the
directors' loan committee and reviewed at the officers' loan committee for
action to be taken. Watch list loans are those loans considered as having
weakness detected in either character, capacity to repay or balance sheet
concerns and prompt management to take corrective action at the earliest
opportunity. Problem and watch list loans generally exhibit one or more of the
following characteristics:
1. Adverse financial trends and condition
2. Decline in the entire industry
3. Managerial problems
4. Customer's failure to provide financial information or other collateral
documentation
5. Repeated delinquency, overdrafts or renewals
Every significant problem credit is reviewed by the loan review process and
assessments are performed quarterly to confirm the risk rating, proper
accounting and the adequacy of loan loss reserve assigned. In addition to this
13
quarterly management review, all problem loans are monitored and evaluated on a
monthly basis by a designated review committee. Depending on the change in
condition, loans may be reassessed concerning allocation of risk, probable
disposition, and potential loss, including changes to the ALL.
After reviewing the gradings in the loan portfolio, management will allocate or
assign a portion of the ALL to categories of loans and individual loans to cover
management's estimate of probable loss. Allocation is related to the grade of
the loan and includes a component resulting from the application of the
measurement criteria of Statements of Financial Accounting Standards No. 114,
"Accounting by Creditors for Impairment of a Loan" ("SFAS 114") and No. 118,
"Accounting by Creditors for Impairment of a Loan-Income Recognition and
Disclosures" ("SFAS 118"). Allocations also are made for unrated loans, such as
credit card loans, based on historical loss experience adjusted for portfolio
activity. The indirect risk in the form of off-balance sheet unfunded
commitments are also taken into consideration. These allocated reserves are
further supplemented by unallocated reserves based on management's estimate
regarding risk of error, local economic conditions and any other relevant
factors. Management then compares the amounts allocated for probable losses to
the current allowance. To the extent that the current allowance is insufficient
to cover management's best estimate of probable losses, management records
additional provision for credit loss. If the allowance is greater than required
at that point in time, provision expense is adjusted accordingly.
Mortgage servicing rights: Another valuation that requires management's judgment
relates to mortgage servicing rights. Essentially, mortgage servicing rights are
established on residential mortgage loans and guaranteed commercial loans that
the Company originate and sell. A portion of the loan's book basis is allocated
to mortgage servicing rights which are retained when a loan is sold, based upon
its relative fair value. The fair value of mortgage servicing rights is the
present value of estimated future net cash flows from the servicing relationship
using current market assumptions for prepayments, servicing costs and other
factors. As the loans are repaid and net servicing revenue is earned, mortgage
servicing rights are amortized against servicing revenue. Net servicing rights
are expected to exceed this amortization expense. However, if the actual
prepayment experience exceeds what was originally anticipated, net servicing
revenues may be less than expected and mortgage servicing rights may be
impaired. This impairment would be recorded as a charge to earnings in the
period in which it became impaired.
Core deposit intangibles: Judgment is used in the valuation of other intangible
assets such as core deposit base intangibles. Core deposit base intangibles
assets of $361,000 have been recorded for core deposits (defined as checking,
money market, savings and time deposits) that have been acquired as a result of
the Kewaunee branch acquisition from M&I Bank. The core deposit base intangible
assets have been recorded using the assumption that they provide a more
favorable source of funding than more expensive wholesale borrowings. An
intangible asset has been recorded for the present value of the difference
between the expected interest expense to be incurred on these deposits and
interest expense that would be expected if these deposits were replaced by
wholesale borrowings, over the expected lives of the core deposits. The Company
currently estimates that the underlying core deposits have lives of seven years.
If future analysis shows these deposits to have a shorter life, then the Company
will write down the asset by expensing the amount that is impaired.
Goodwill: The Company has goodwill assets on the books as a result of two prior
acquisitions. Goodwill is tested annually for impairment. Those tests inherently
involve management's judgment as to factors such as an estimation of the fair
value of a reporting unit; screening for potential impairment and measuring the
amount of the impairment. There was no impairment of goodwill in 2003 or 2002.
In the event of goodwill impairment, that amount would be charged to earnings in
the period in which the impairment is determined.
Overview
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.
From an industry and national perspective, the Company's profitability, like
most financial institutions, is dependent to a large extent upon net interest
income. Results of operations are also affected by the provision for loan
losses, operating expenses such as salaries and employee benefits, occupancy and
other operating expenses, including
14
income taxes, and to a lesser extent, non-interest income such as trust
revenues, loan servicing fees and service charge income derived from deposit
accounts. Economic conditions, competition and the monetary and fiscal policies
of the Federal government in general, significantly affect financial
institutions, including the Company. During 2003, the Federal government's focus
was marked by steady low interest rates intended to stabilize the current
economy and provide stimulation for future economic growth. Lending activities
are also influenced by regional and local economic factors. Some specific
factors may include the demand for and supply of housing, competition among
lenders, interest rate conditions and prevailing market rates on competing
investments, customer preferences and levels of personal income and savings in
the Company's market area.
In the last several years, the Company has initiated strategic changes to its
bank operations intended to enhance the Bank's utilization of resources, and the
effectiveness of customer services within its primary market area. Bank has
developed an internal customer relationship management system ("CRM") to manage
and to more effectively market to its internal customer base.
Since the latter part of 2001, the Company has dedicated resources to its goal
of improving asset quality. Improvements have been achieved relative to
collections or recoveries from the disposition of collateral, especially related
to the Company's level of non-performing commercial loans. Credit risk has
improved in the commercial loan portfolio as a result of improved underwriting
and more extensive collection efforts through the addition of legal and
collection staff.
Results of Operations
Earnings Summary
The following is a brief summary of some of the factors which have affected our
earnings in 2003. See the balance of this section for a more thorough
discussion.
The Company reported net income of $8.0 million compared to $8.7 million and
$7.5 million for 2002 and 2001, respectively. Basic and diluted earnings per
share were $1.06 and $1.04, respectively, for 2003 compared to $1.17 and $1.15
for 2002 and $1.01 and $0.99 for 2001. Return on average assets for the year
ended December 31, 2003 was 0.87% and 1.00% and 0.93% for 2002 and 2001,
respectively. The return on average equity was 11.86% for 2003 and 13.82% and
13.37% for 2002 and 2001, respectively. Cash dividends declared in 2003
increased 8.2% to $0.53 per share compared with $0.49 in 2002. This compares to
an increase of 8.9% in dividends declared in 2002 as compared to 2001.
Net income for 2001 reflects amortization expense of $486,000 of goodwill
related to the acquisition in 1996 of Four Seasons and in 1998 of Evergreen.
This expense reduced after-tax net income in 2001 by $486,000 or earnings per
share by $0.07. Goodwill is no longer amortized, but, instead, is tested
annually for impairment. If impairment were to be found, the net effect would be
a reduction in net income in the year that impairment was measured.
The Company earned net interest income of $29.0 million and $29.4 million in
2003 and 2002, respectively. The continuing national trend of historically low
interest rates produced a decrease in net interest income of 1.3% in 2003 from
2002 despite the increase in average balances. The changes in the loan and
security portfolios, discussed later, generally reflect downward trends in rates
associated with lower risk assets in addition to the current market rates.
The provision for loan losses in 2003 and 2002 were $5.7 million. The provisions
reflected the increases in net loan charge-offs, the high level of
non-performing loans, risk levels inherent in the loan portfolio and the
changing mix of the overall loan portfolio.
Non-interest income during 2003 decreased $322,000 or 2.9% when compared to
2002. The primary factors decreasing non-interest income were a reduction in
fees for other services to customers, a decrease in securities gains and a
decrease in other income. These decreases were offset by an increase in
fiduciary fees, an increase in loan servicing fee income and increased gains on
sales of loans. Death benefits recognized in 2002 and gross revenues from bank
subsidiaries realized in 2002 accounted for much of the difference in other
income for 2003 relative to 2002.
15
Non-interest expense increased $641,000 during 2003, or 2.7% over 2002 levels.
Factors contributing to the increase were increased personnel and benefits
expenses and increased expenses related to the operation of other real estate
owned. Increases in these expenses were offset by a significant decrease in
expenses related to our former Arborview subsidiary, which was sold in February
2003.
The major components of net income and changes in these components are
summarized in Table 1 for years ended December 31, 2003, 2002 and 2001 and are
discussed in more detail on the following pages.
TABLE 1: NET INCOME COMPONENTS
Years ended December 31,
--------------------------------------------------------------
2002 to 2003 2001 to 2002
2003 2002 % change 2001 % change
-------- -------- ------------ -------- ------------
(dollars in thousands)
Net interest income $ 29,008 $ 29,376 (1.3%) $ 26,970 8.9%
Provision for loan
losses $ 5,650 $ 5,700 (0.9%) $ 2,880 97.9%
Noninterest income $ 10,691 $ 11,013 (2.9%) $ 6,511 69.1%
Noninterest expense $ 24,032 $ 23,391 2.7% $ 20,975 11.5%
Income before $ 10,017 $ 11,298 (11.4%) $ 9,626 17.4%
Income taxes
Income tax expense $ 2,060 $ 2,575 (20.0%) $ 2,091 23.1%
Net income $ 7,957 $ 8,723 (8.8%) $ 7,535 15.8%
Net Interest Income
Net interest income is impacted by the difference between rates earned on
interest-earning assets and rates paid on interest-bearing liabilities (interest
rate spread) and the relative amounts of interest-earning assets and
interest-bearing liabilities. The interest income and interest expense of
financial institutions are significantly affected by general economic
conditions, competition, policies of regulatory authorities and other factors.
Net interest income (on a tax equivalent basis) is the Company's principal
source of revenue accounting for 73.9% of total income in 2003, as compared to
73.7% in 2002 and 81.3% in 2001. The reductions in 2003 and 2002 relative to
2001 reflect a lower rate environment effectively compressing net interest
margin in addition to an increase in non-performing assets resulting in
additional non-accrual interest for the period. Net interest income represents
the difference between interest earned on loans, investments and other interest
earning assets offset by the interest expense attributable to funding sources,
principally deposits and borrowings. Interest rate 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 interest income earned. Tax-exempt interest income is
adjusted to a level that reflects such income as if it were fully taxable.
Net interest income in the consolidated statements of income (which excludes the
taxable equivalent adjustment on tax exempt assets) was $29.0 million in 2003,
compared to $29.4 million in 2002 and $27.0 million in 2001. The taxable
equivalent adjustments (the adjustments to bring tax-exempt interest to a level
that would yield the same after-tax income had that income been subject to
taxation, using a 34% tax rate) of $1.2 million for 2003 and $1.4 million for
2002 and 2001, resulted in fully taxable equivalent ("FTE") net interest income
of $30.2 million, $30.8 million and $28.3 million, respectively. The decline in
2003 net interest income of $600,000 was in spite of an increase in the volume
of net average earning assets of $17.7 million. A lower rate environment has
impacted the
16
repricing of assets, primarily loans, to a greater degree than the liability
side of the balance sheet, resulting in a decreased net interest margin.
Average-earning assets increased 5.6% offset by an increase of 3.7% in average
interest-bearing liabilities. The benefit from an increase in earning assets,
non-interest bearing deposits and a decrease in the cost on interest paying
liabilities were offset, in part, by an increase in interest-bearing liabilities
and a decrease in the yield on interest earning assets. As a result, interest
income decreased 8.1% while interest expense for 2003 decreased 16.8%.
Interest rate spread and net interest margin are terms utilized to measure and
explain changes in net interest income. Interest rate spread is the difference
between the yield on earning assets ("EAs") and the rate paid on
interest-bearing liabilities ("IBLs") that fund those assets. The net interest
margin is expressed as tax-equivalent net interest income as a percentage of
average EAs. The net interest margin exceeds the interest rate spread because of
the use of non-interest bearing sources of funds (net free funds), principally
composed of demand deposits and stockholders' equity, to fund a portion of EAs.
To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt
loans and securities is computed on an FTE basis. As a result, the level of
funds available without interest cost is an important factor affecting the
ability to increase net interest margin.
Table 2 provides average balances of EAs and IBLs, the associated income and
expense, and the corresponding interest rates earned and paid, as well as net
interest income, interest rate spread, and net interest margin on an FTE basis
for the three years ended December 31, 2003. Tables 3 through 4 present
additional information for the discussion of FTE net interest income, interest
rate spread, and net interest margin.
As indicated in Tables 2 and 3, increases in volume and changes in the mix of
both EAs and IBLs added $2.3 million to FTE net interest income, while changes
in the rates resulted in a $2.8 million decrease, for a net decrease of
$544,000.
Average loans outstanding grew to $678.0 million in 2003 from $635.4 million in
2002, an increase of 6.7%. The increase in loan volume was a significant
contributing factor to net interest income. Average loans outstanding increased
to $635.4 million in 2002 from $588.0 million in 2001, an increase of 8.1%. The
mix of average loans to average total assets increased to 74.0% in 2003 from
72.8% in 2002 and from 72.7% in 2001. The relationship of a higher volume of
loans as a percentage of the asset mix has provided a source of higher yielding
assets, which has contributed to net interest income.
The year 2003 saw a decrease of the interest rate spread for the Company in
spite of a lower interest rate environment. The interest rate spread decreased
26 basis points in 2003 to 3.35% from 3.61% in 2002, as the average yield on
earning assets decreased 86 basis points while the average rate paid on
interest-bearing liabilities decreased 60 basis points over the same period. In
contrast, interest rate spread increased 27 basis points in 2002 compared to
2001 results. The decrease in the Company's earning assets yield reflects a
lower rate environment impacting rates on the variable priced loans and
re-pricing fixed rate loans (for competitive reasons) for the year 2003.
Decreased investment interest income, which resulted from an increased
investment portfolio, offset by lower yields on the investment portfolio, have
contributed to some of the decrease in the yields on interest earning assets. A
lower rate environment also affected the funding side of the balance sheet.
Yields on interest-paying liabilities decreased 60 basis points. Decreased
interest costs resulted from a lower rate environment offset to a lesser extent
by increased competition for retail deposits and increased balances in time
deposit accounts. Yields on interest bearing deposits decreased 60 basis points
to 2.21% in 2003 from 2.81% in 2002.
The lower rate environment also had an effect in reducing yields on the
wholesale funding side of the balance sheet. Yields on short-term borrowings
decreased 65 basis points in 2003 compared to 2002, while yields on other
borrowings decreased 73 basis points to 3.12% in 2003 from 3.85% in 2002.
The net interest margin for 2003 was 3.60% compared to 3.87% in 2002. The
decrease in net interest margin was in part related to a general decline in the
interest rate environment offset slightly by an increase in the free funds ratio
and a decrease in non-accrual loans. The steady decrease in general interest
rates, including the Company's commercial loan Prime Rate, which commenced
during 2001, provided the general low interest rate environment that continued
to drive the yield on commercial and other variable type loans lower into the
year 2003. Increased competition, especially as it relates to the commercial
loan portfolio, negatively affected net interest margin. The
17
free funds ratio, or the level of non-interest bearing funds that support
earning assets, improved to 19.5% from 18.5% in 2002.
The net interest margin for 2002 was 3.87% compared to 3.79% in 2001 as
re-pricing opportunities occurred more readily on the funding side of the
balance sheet relative to the asset side of the balance sheet. The increase in
2002 during a declining interest rate environment occurred as the result of an
increase in the interest rate spread and an increase in the free funds ratio
offset by an increase in non-accrual loans.
The ratio of average earning assets to average total assets measures
management's ability to employ overall assets for the production of interest
income. This ratio was 91.6% in 2003 compared with 91.1% in 2002 and 92.5% in
2001. The ratio increased in 2003 as a result of a decrease in non-accrual
loans.
Competition in the financial services industry will also affect net interest
margin. Spreads will be a focus of management's attention, as the Company
constantly seeks to attract lower cost core deposits, service the needs of
customers, and provide attractively priced products. Competition for high
quality assets will also affect asset yields and result in less interest income.
Changes in the levels of market interest rates also affect net income, but are
less directly under the control of the Company. Although a lower rate
environment has been experienced, management believes that a gradual increase in
interest rates will not adversely affect the earning capacity of the Company.
Past experience has shown that, although the Company remains in a short-term
positive interest rate sensitivity gap, deposits tend not to be re-priced as
quickly as loans in a rising rate scenario and are re-priced more frequently in
a falling interest rate environment. More discussion on this subject is
referenced in the section titled "Interest Rate Risk" below.
TABLE 2: AVERAGE BALANCES AND INTEREST RATES (INTEREST AND RATES ON A
TAX-EQUIVALENT BASIS)
Year ended December 31,
-----------------------------------------------------------------------------------------------------
2003 2002 2001
-------------------------------- -------------------------------- ---------------------------------
Average Average Average Average Average Average
Balance Interest Rate Balance Interest Rate Balance Interest Rate
--------- --------- ------- --------- --------- ------- --------- --------- -------
(dollars in thousands)
ASSETS:
Earning Assets
Loans (1)(2)(3) $ 678,041 $ 635,368 $ 587,995
Less: non-accruals (11,625) (15,665) (10,613)
--------- --------- ---------
Net loans 666,416 $ 40,129 6.02% 619,703 $ 42,826 6.91% 577,382 $ 49,313 8.54%
U.S. Treasuries 825 51 6.18% 1,235 77 6.23% 1,229 78 6.35%
Agencies 102,323 4,115 4.02% 97,684 5,239 5.36% 99,972 6,202 6.20%
State and Municipal
obligations (1) 53,609 3,696 6.89% 57,701 4,163 7.21% 53,158 4,051 7.62%
Other Securities 10,063 668 6.64% 7,671 510 6.65% 7,671 483 6.30%
Federal funds sold 1,669 20 1.20% 1,132 19 1.68% 5,347 174 3.25%
Other money market
instruments 4,718 38 0.81% 10,043 149 1.48% 2,963 78 2.63%
--------- --------- ----- --------- --------- ----- --------- --------- ----
Total earning assets $ 839,623 $ 48,717 5.80% $ 795,169 $ 52,983 6.66% $ 747,722 $ 60,379 8.08%
--------- --------- ----- --------- --------- ----- --------- --------- ----
Allowance for loan
losses (12,581) (8,383) (7,349)
Non-accrual loans 11,625 15,665 10,613
Cash and due from
banks 17,622 18,447 16,288
Other assets 60,349 52,176 41,162
--------- --------- ---------
Total assets $ 916,638 $ 873,074 $ 808,436
========= ========= =========
18
LIABILITIES AND
STOCKHOLDERS'
EQUITY
Interest bearing
Liabilities
NOW accounts $ 74,998 $ 674 0.90% $ 53,170 $ 526 0.99% $ 44,015 $ 514 1.17%
Savings accounts 196,598 1,763 0.90% 201,344 3,038 1.51% 197,993 6,940 3.51%
Time deposits 387,717 12,149 3.13% 361,555 13,771 3.81% 305,012 17,001 5.57%
--------- --------- ----- --------- --------- ----- --------- --------- ----
Total interest-bearing
Deposits 659,313 14,586 2.21% 616,069 17,335 2.81% 547,020 24,455 4.47%
Short-term borrowings 10,141 137 1.35% 18,708 375 2.00% 19,351 1,084 5.60%
Securities sold under
agreement to
repurchase 1,202 12 1.00% 2,332 38 1.63% 2,403 94 3.91%
Other borrowings 65,250 2,034 3.12% 72,534 2,790 3.85% 94,589 4,975 5.26%
Trust preferred 16,598 1,695 10.21% 16,100 1,645 10.22% 14,031 1,430 10.19%
Long term debt 53 2 3.77% 106 5 4.72% 159 15 9.43%
--------- --------- ----- --------- --------- ----- --------- --------- ----
Total interest-bearing
Liabilities $ 752,557 $ 18,466 2.45% $ 725,849 $ 22,188 3.06% $ 677,553 $ 32,053 4.73%
Demand deposits 88,642 76,030 67,012
Accrued expenses and
other liabilities 8,322 8,069 7,519
Stockholders' equity 67,117 63,126 56,352
--------- --------- ---------
Total liabilities and
stockholders' equity $ 916,638 $ 873,074 $ 808,436
========= ========= =========
Net interest income
and rate spread $ 30,251 3.35% $ 30,795 3.61% $ 28,326 3.34%
Net interest margin 3.60% 3.87% 3.79%
(1) The yield on tax exempt loans and securities is computed on a
tax-equivalent basis using a tax rate of 34% for all periods
presented.
(2) Nonaccrual loans and loans held for sale have been included in the
average balances.
(3) Interest income includes net loan fees.
TABLE 3: RATE/VOLUME ANALYSIS (1)
2003 compared to 2002 2002 compared to 2001
Increase (Decrease) due to Increase (Decrease) due to
-------------------------------- ---------------------------------
Volume Rate Net Volume Rate Net
-------- -------- -------- -------- --------- --------
(dollars in thousands)
Interest income:
Loans (2) $ 3,021 $ (5,718) $ (2,697) $ 3,270 $ (9,757) $ (6,487)
U.S. treasuries (24) (2) (26) 1 (2) (1)
Agencies 288 (1,412) (1,124) (251) (712) (963)
State and municipal
obligations (2) (265) (202) (467) 264 (152) 112
Other securities 56 102 158 86 (59) 27
Federal funds sold 8 (7) 1 (104) (51) (155)
Other money market
instruments (61) (50) (111) 146 (75) 71
-------- -------- -------- -------- --------- --------
19
2003 compared to 2002 2002 compared to 2001
Increase (Decrease) due to Increase (Decrease) due to
-------------------------------- ---------------------------------
Volume Rate Net Volume Rate Net
-------- -------- -------- -------- --------- --------
(dollars in thousands)
Total earning assets $ 3,023 $ (7,289) $ (4,266) $ 3,411 $ (10,807) $ (7,396)
-------- -------- -------- -------- --------- --------
Interest expense:
NOW accounts $ 206 $ (58) $ 148 $ 99 $ ( 87) $ 12
Savings accounts (57) (1,218) (1,275) 84 (3,986) (3,902)
Time deposits 908 (2,530) (1,622) 2,653 (5,883) (3,230)
Short term borrowings (144) (94) (238) (24) (685) (709)
Securities sold
under agreement to
repurchase (15) (11) (26) (2) (54) (56)
Other borrowings (254) (502) (756) (1,004) (1,181) (2,185)
Trust preferred 51 (1) 50 211 4 215
Long term debt (2) (1) (3) (4) (6) (10)
-------- -------- -------- -------- --------- --------
Total
interest-bearing
liabilities $ 693 $ (4,416) $ (3,722) $ 2,012 $ (11,877) $ (9,865)
Net interest income $ 2,330 $ (2,874) $ (544) $ 1,399 $ 1,070 $ 2,469
======== ======== ======== ======== ========= ========
(1) The change in interest due to both rate and volume has been allocated
proportional to the relationship to the dollar amounts of the change
in each.
(2) The yield on tax-exempt loans and securities is computed on an FTE
basis using a tax rate of 34% for all periods presented.
20
TABLE 4: SELECTED AVERAGE BALANCES
Percent 2003 as % of 2002 as % of
2003 2002 Change Total Assets Total Assets
--------- --------- ------- ------------ ------------
(dollars in thousands)
ASSETS
Loans, net of
non-accrual loans $ 666,416 $ 619,703 7.5% 72.7% 71.0%
Investment securities
Taxable 114,058 107,290 6.3% 12.4 12.3
Tax-exempt 52,762 57,001 (7.4)% 5.8 6.5
Short-term investments 6,387 11,175 (42.8)% 0.7 1.3
--------- --------- ----- ----- -----
Total earning assets 839,623 795,169 5.6% 91.6 91.1
Other assets 77,015 77,905 (1.1)% 8.4 8.9
--------- --------- ----- ----- -----
Total assets $ 916,638 $ 873,074 5.0% 100.0% 100.0%
========= ========= ===== ===== =====
LIABILITIES AND
STOCKHOLDERS' EQUITY
Interest-bearing deposits $ 659,313 $ 616,069 7.0% 71.9% 70.6%
Short-term borrowings 76,593 93,574 (18.1)% 8.4 10.7
Trust preferred 16,598 16,100 3.1% 1.8 1.9
Long-term debt 53 106 (50.0)% 0.0 0.0
--------- --------- ----- ----- -----
Total interest-bearing
Liabilities 752,557 725,849 3.7% 82.1 83.2
Demand deposits 88,642 76,030 16.6% 9.7 8.7
Accrued expenses 8,322 8,069 3.1% 0.9 0.9
Stockholders' equity 67,117 63,126 6.3% 7.3 7.2
--------- --------- ----- ----- -----
Total liabilities and
Stockholders'equity $ 916,638 $ 873,074 5.0% 100.0% 100.0%
========= ========= ===== ===== =====
TABLE 5: DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY
For the years
-------------------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(dollars in thousands)
ASSETS
Cash and due from banks $ 18,275 $ 18,990 $ 16,896 $ 15,142 $ 15,978
Investment securities
U.S. Treasuries 812 1,183 1,173 1,164 1,156
Agencies 99,770 93,831 98,040 96,757 89,863
State and municipal
obligations 51,918 55,544 52,082 50,263 50,954
Other securities 14,096 18,612 10,026 7,440 5,019
Market adjustment on
AFS securities 4,289 4,621 3,064 (2,775) 386
--------- --------- --------- --------- ---------
Total investments $ 170,885 $ 173,791 $ 164,385 $ 152,849 $ 147,378
--------- --------- --------- --------- ---------
Federal funds sold 1,669 1,132 5,347 14 5,361
Loans, net of unearned
income 678,041 635,368 587,995 505,892 421,541
Reserve for loan losses (12,581) (8,383) (7,349) (7,999) (8,924)
--------- --------- --------- --------- ---------
Net loans 665,460 626,985 580,646 497,893 412,617
21
For the years
-------------------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(dollars in thousands)
Bank premises and
equipment 21,550 21,769 21,033 20,128 16,795
Other real estate owned 1,170 990 1,501 562 287
Other assets 37,629 29,417 18,628 19,858 18,423
--------- --------- --------- --------- ---------
Total assets $ 916,638 $ 873,074 $ 808,436 $ 706,446 $ 616,839
========= ========= ========= ========= =========
LIABILITIES AND
STOCKHOLDER'S EQUITY
Demand deposits $ 88,642 $ 76,030 $ 67,012 $ 61,214 $ 56,755
NOW accounts 74,998 53,170 44,015 44,965 47,313
Savings deposits 196,598 201,344 197,993 164,858 141,972
Time deposits 387,717 361,555 305,012 252,086 246,782
--------- --------- --------- --------- ---------
Total deposits $ 747,955 $ 692,099 $ 614,032 $ 523,123 $ 492,822
Short term borrowings $ 10,141 $ 18,708 $ 19,351 $ 41,798 $ 10,812
Securities sold under
agreement to repurchase 1,202 2,332 2,403 2,213 3,657
Other borrowings 65,250 72,534 94,589 83,629 56,466
Long term debt 53 106 159 211 265
Trust preferred
securities 16,198 16,100 14,031 -- --
Other liabilities 8,322 8,069 7,519 6,718 6,882
--------- --------- --------- --------- ---------
Total liabilities $ 849,521 $ 809,948 $ 752,084 $ 657,692 $ 570,904
Common stock $ 37,775 $ 37,486 $ 37,456 $ 37,333 $ 20,996
Additional paid in
capital 7,640 7,328 7,625 7,125 6,560
Retained earnings 19,516 15,950 9,902 7,234 18,743
Net unrealized gains
(losses) on AFS
securities 2,811 2,987 1,994 (2,313) 261
Treasury stock (625) (625) (625) (625) (625)
--------- --------- --------- --------- ---------
Total equity $ 67,117 $ 63,126 $ 56,352 $ 48,754 $ 45,935
--------- --------- --------- --------- ---------
Total liabilities and
stockholders' equity $ 916,638 $ 873,074 $ 808,436 $ 706,446 $ 616,839
========= ========= ========= ========= =========
Provision for Loan Losses
The provision for loan losses ("PFLL") is the periodic cost determined, not less
than quarterly, of providing an allowance for anticipated future loan losses. In
any accounting period, the PFLL is based on the methodology used and
management's evaluation of the loan portfolio, especially non-performing and
other potential problem loans, taking into consideration many factors, including
loan growth, net charge-offs, changes in the composition of the loan portfolio,
delinquencies, management's evaluation of loan quality, general economic factors
and collateral values.
The Company's loan review department performs a risk rating analysis as an
integral part of the review of each loan portfolio. For the commercial and
commercial real estate portfolios, the risk rating analysis includes a grading
system following a standard risk-rating matrix. Based upon this matrix, the
Company determines a risk rating assignment an appropriate measure to each loan
examined. As a result, the Company has provided $5.7 million in PFLL for 2003.
22
The PFLL in 2003 at $5.7 million compares to a PFLL of $5.7 million for 2002 and
$2.9 million for 2001. Net charge-offs in 2003 were $4.9 million compared with
net charge-offs of $2.3 million in 2002 and $1.9 million in 2001. Net
charge-offs as a percentage of average loans is a key measure of asset quality.
Net charge-offs to average loans were 0.72% in 2003 compared with 0.36% in 2002
and 0.32% in 2001. The increase in net charge-offs relates principally to a $2.6
million commercial loan charge-off in the fourth quarter of 2003 that had been
previously disclosed. Management believes that the current provision conforms
with the Company's loan loss reserve policy and is adequate in view of the
present condition of the Company's loan portfolio. However, a decline in the
quality of our loan portfolio, as a result of general economic conditions,
factors affecting particular borrowers or our market area, or otherwise, could
affect the adequacy of the allowance. If there are significant charge-offs
against the allowance, or we otherwise determine that the allowance is
inadequate, we will need to make higher provisions in the future. See "Risk
Management and the Allowance for Loan Losses" below for more information related
to non-performing loans.
Non-Interest Income
Total non-interest income for 2003, excluding securities transactions, was $10.7
million, a $322,000 decrease from 2002, or 2.9%. In 2002, total non-interest
income was $4.5 million more than 2001, a 69.1% increase. Trust service fees,
fees from loan servicing, gains from sales of loans and service charges continue
to be the primary components of non-interest income as evidenced in Table 6.
TABLE 6: NONINTEREST INCOME
Years ended December 31, % Change from prior year
------------------------------ ------------------------
2003 2002 2001 2003 2002
-------- -------- -------- --------- ----------
(dollars in thousands)
Trust service fees $ 677 $ 637 $ 664 6.3% (4.1)%
Loan servicing income $ 1,470 $ 1,279 $ 1,265 14.9% 1.1%
Mortgage servicing rights $ 539 $ 308 $ 400 75.0% (23.0)%
Gains from sale of loans $ 1,910 $ 1,425 $ 873 34.0% 63.2%
Service charges on
deposit accounts $ 2,857 $ 2,853 $ 1,836 0.1% 55.4%
Other fee income $ 669 $ 720 $ 608 (7.1)% 18.4%
Financial service income $ 527 $ 575 $ 300 (8.3)% 91.7%
Bank owned life ins $ 685 $ 332 $ 0 106.3% NM
Death benefit in excess
of cash surrender value $ 0 $ 754 $ 0 NM NM
Arborview revenues $ 67 $ 705 $ 0 NM NM
Gain on sale-Arborview
assets $ 538 $ 0 $ 0 NM NM
Securities gains $ 0 $ 509 $ 0 NM NM
Other income $ 752 $ 916 $ 565 (17.9)% 62.1%
-------- -------- -------- ----- -----
Total noninterest income $ 10,691 $ 11,013 $ 6,511 (2.9%) 69.1%
======== ======== ======== ===== =====
Trust fees increased $40,000 to $677,000 in 2003 compared to 2002, primarily as
a result of increased trust business assets under investment. This compared to a
decrease of $27,000 in 2002 compared to 2001, primarily as a result of a lower
market values on various trust accounts for which fees are assessed.
Loan servicing fees increased $191,000 to $1.5 million in 2003. This followed an
increase of $14,000 to $1.3 million in 2002. With mortgage market rates
remaining at attractive levels throughout 2003, strong home purchase and
refinance activity improved 2003 results. Mortgages serviced for secondary
market placements (primarily Federal Home Loan Mortgage Corporation "FHLMC")
were $117.8 million and $74.6 million at December 31, 2003 and 2002,
respectively.
23
The strong mortgage market also provided improvement with respect to increases
in mortgage servicing rights income and gains from sales of loans. Mortgage
servicing rights improved $231,000 in 2003 resulting in income of $539,000
compared to $308,000 in 2002.
Gains from the sale of mortgage loans totaled $1.7 million in 2003 compared to
$1.2 million in 2002. In addition, gains from the sale of commercial loans
totaled $176,000 in 2003 compared to $183,000 in 2002. An increase in mortgage
loan business sold during 2003 amounted to $135.9 million of loans sold compared
to $104.8 million of mortgage loans sold in 2002. Total loans sold during 2003
were $140.0 million compared to $108.6 million in 2002.
The general level and direction of interest rates directly influence the volume
and profitability of the mortgage loan business. Refinancing activity in
mortgage loans began to decline in the fourth quarter of 2003. Therefore there
can be no assurance as to the future amounts of income that will be received in
the origination of fees and gains on sales of residential mortgage loans and,
given current trends, decreases are likely.
The Company capitalizes the estimated market value of Mortgage Servicing Rights
("MSR") into income upon the origination and sale of each mortgage loan. The
Company amortizes MSR in proportion to the servicing income it receives over the
estimated life of the underlying mortgages, considering prepayment expectations
and refinancing patterns. In addition, the Company amortizes, in full, any
remaining MSR balance that is specifically associated with a serviced loan that
is refinanced or paid-off.
Service charges on deposit accounts, representing 26.7% of total non-interest
income in 2003, totaled $2.9 million in both 2003 and 2002, despite an 8.1%
increase in the average balance of deposits for 2003 compared to 2002. The
majority of the deposit pricing changes had been made in early 2002 therefore
minimizing the impact on improvement in 2003. The results of 2002 provided an
increase of $1.0 million, or 55.4%, over 2001 results accounting for the
improvement in fee income generated for other services provided to customers.
Financial services income decreased $48,000, or 8.3%, to $527,000 in 2003 as
compared to 2002 as a result of reduced sales staff on average during the year.
As a result of a purchase of $4 million and $13 million in business owned life
insurance ("BOLI") made during 2003 and 2002, respectively, income made during
2003 and 2002 amounted to $685,000 and $332,000, respectively. The purchase of
$13 million was made in mid-year 2002, therefore, the average investment held in
BOLI was significantly less in 2002.
Death benefits were recognized in excess of cash surrender value in the amount
of $754,000 in 2002. Life insurance is held on various directors as a funding
vehicle for several deferred compensation agreements the Company has with them.
Securities gains for the year ended December 31, 2002 totaled $509,000. There
were no securities gains or losses taken in 2003.
Included in the 2003 results was $67,000 of revenues generated by the Arborview
LLC ("Arborview") operations compared to $705,000 in revenues generated in 2002.
Arborview was a subsidiary formed to manage a community based residential
facility acquired in January 2002 as a result of a deed in lieu of foreclosure;
it was sold in February 2003. A gain on sale of Arborview fixed assets totaling
$538,000 occurred as a result of the sale in 2003.
Other income decreased $164,000 to $752,000 in 2003 from $916,000 in 2002. Gains
of $107,000 related to the sale of bank land not deemed necessary for
development was recorded in 2002. Included in other income was income of
$106,000 on previously amended tax returns received during the year 2003
compared to $133,000 in 2002. Undistributed income from United Financial
Services, Inc., the Bank's data servicing subsidiary decreased $50,000 as a
result of decreased earnings to $333,000, from the data processing subsidiary.
24
Non-Interest Expense
Non-interest expense in 2003 increased to $24.0 million, a $641,000, or 2.7%
increase compared to 2002 results, primarily as a result of increased personnel,
equipment, data processing, and other operating expense. The acquisition of the
Kewaunee branch did not have a material effect on operating results in 2003, nor
does management expect it to have such an effect in the future. This followed a
$2.4 million or 11.5% increase in 2002 as compared to 2001. Primary categories
impacting the change between 2003 and 2002 are noted in Table 7 below.
TABLE 7: NONINTEREST EXPENSE
Years ended December 31, % Change from prior year
------------------------------ ------------------------
(dollars in thousands)
---------------------------------------------------------
2003 2002 2001 2003 2002
-------- -------- -------- --------- ----------
Personnel $ 14,183 $ 13,743 $ 11,923 3.2% 15.3%
Occupancy $ 2,087 $ 2,163 $ 1,834 (3.5%) 17.9%
Equipment $ 1,438 $ 1,422 $ 1,401 1.1% 1.5%
Data processing $ 987 $ 942 $ 893 4.8% 5.5%
Business development
and advertising $ 737 $ 628 $ 594 17.4% 5.7%
Stationery and supplies $ 499 $ 611 $ 482 (18.3)% 26.8%
Director fees $ 263 $ 266 $ 285 (1.1)% (6.7)%
FDIC insurance $ 115 $ 116 $ 110 (0.9)% 5.5%
Goodwill amortization $ 0 $ 0 $ 486 NM NM
Mortgage servicing rights
amortization $ 411 $ 260 $ 204 58.1% 27.5%
Legal and professional $ 250 $ 230 $ 256 8.7% (10.2)%
Operation of other real
Estate $ 378 $ 203 $ 248 86.2% (18.1)%
Other $ 2,684 $ 2,807 $ 2,259 (4.4)% 24.3%
-------- -------- -------- ----- -----
Total noninterest expense $ 24,032 $ 23,391 $ 20,975 2.7% 11.5%
======== ======== ======== ===== =====
The above non-interest expenses include expenses related to the Arborview
subsidiary, the assets of which were sold in 2003. To help identify those
expenses, which will not continue due to our sale of the Arborview assets, a
breakdown of the Arborview expenses included above is set forth in the following
table 8:
TABLE 8: ARBORVIEW EXPENSES
Years ended December 31,
------------------------
(dollars in thousands)
------------------------
2003 2002
-------- --------
Personnel $ 105 $ 535
Occupancy $ 23 $ 188
Equipment $ 4 $ 14
Stationary and supplies $ 7 $ 77
Other $ 85 $ 120
-------- --------
Total Arborview expenses $ 224 $ 934
Salaries and employee benefits expense is the largest component of non-interest
expense and totaled $14.2 million in 2003, an increase of $440,000, or 3.2%, as
compared to 2002 results. The increase in 2003 primarily resulted from staffing
increases, increased benefit costs, and normal salary increases offset by a
decrease in bonus expense. Salary costs increased $324,000, or 3.2%, for 2003
compared to 2002 results as a result of increased staffing and normal salary
increases. The increase in salary expense was partially offset by a decrease in
Arborview related personnel
25
expenses of $420,000. The number of full-time equivalent employees increased to
302 in 2003 from 293 in 2002, an increase of 3.1%. Employee levels in 2002
increased to 293 from 286 in 2001, an increase of 5.1%.
Benefit costs, principally for health insurance and pension costs, represent the
remaining increase in personnel-related costs. These costs increased $429,000,
or 23.5%. The current trend for increased health insurance and pension costs is
expected to continue into 2004. Salary and employee benefits expense in 2002
totaled $13.7 million, an increase of $1.8 million, or 15.3%, as compared to
2001 results. The 2002 increase resulted primarily from staffing increases,
bonus expense, increased benefit costs, and normal salary increases. Management
will continue its efforts to control salaries and employee benefits expense,
although increases in these expenses are likely to continue to occur in future
years.
Bonus expense in 2003 was $240,000 compared to $588,000 in 2002. The decrease
occurred as a result of bonus expense arising from the Company's
Pay-for-Performance Program in 2003. This program is designed to reward various
divisions upon achievement of certain goals related to improvement in income and
on return on equity. The Company did not achieve its return on equity goals and,
accordingly, bonus expense was reduced.
The Company's 401(k) profit sharing plan, including a money purchase plan
initiated in 1999, covering all employees who qualify as to age and length of
service increased to $835,000, an increase of $25,000 over 2002 levels. Expenses
in the same category in 2002 were up $97,000 over 2001 levels as a result of
additional employees who qualified to participate in the plan.
Net occupancy expense for 2003 showed a decrease of $76,000 as compared to 2002
for a total of $2.1 million. A reduction in depreciation expense and real estate
tax expense accounted for the balance of the decrease in 2003. This increase
followed an increase of $329,000 in 2002 as a result of additional depreciation
expense, increased real estate tax expense, and increased other occupancy costs.
Equipment expense for 2003 increased slightly, $16,000 compared to 2002. This
followed an increase of $21,000 in 2002. The increase in 2003 resulted from
contract expense related to ongoing maintenance on various equipment owned by
the Bank.
Data processing expense in 2003 increased $45,000 due to an increase in the
volume of transaction activity processed and technology enhancements. This
followed an increase of $49,000 in 2002 compared to 2001. Management estimates
that data processing expense should show minimal increases in the next several
years with adjustments related only to any volume increases incurred by the
Company.
Business development and advertising expense increased $109,000 compared to
2002. More emphasis was placed on business referral and development calls on new
business and for customer retention programs in 2003 accounting for the balance
of the increase. This compared to an increase of $34,000 in 2002 compared to
2001.
Supplies expense shows a decrease of $112,000, or 18.3%, in 2003 as compared to
2002. This decrease occurred primarily as a result of expenses related to the
Arborview operation. This compared to an increase of $129,000, or 26.8%, in 2002
as compared to 2001, primarily related to Arborview.
Payments to regulatory agencies decreased $1,000 to $115,000 for 2003. This
followed an increase of $6,000 in 2002 compared to 2001. The Bank's risk
classification has remained at 1A, rating assigned to well-capitalized
institutions. For additional information regarding the Company's capital
adequacy, see "Capital Resources" below.
Legal and professional expense for 2003 increased $20,000, to $250,000 or an
8.7% increase. The increase was impacted by the levels of problematic loans and
will have a similar impact in 2004. This compares to 2002 expenses of $230,000
compared to $256,000 in 2001.
Other real estate expenses are netted against income received in the
determination of net other real estate owned expense (income). As a result, the
Company has shown varied results. Other real estate owned showed net expense of
$378,000 in 2003. Gains of $46,000 from four commercial property sales and
$42,000 from seven residential property sales were realized in 2003. These were
offset by losses of $23,000 from the sale of three commercial properties and two
residential properties. Various operating expenses, net of income, of other real
estate totaling
26
$443,000 occurred in 2003. Other real estate owned expenses resulted in net
expense of $203,000 in 2002. Gains of $101,000 from four commercial property
sales and $12,000 from three residential property sales were realized in 2002.
These were offset by losses of $71,000 from the sale of five commercial
properties and two residential properties. Various operating expenses, net of
income, of other real estate totaling $245,000 occurred in 2002.
During 2002, the Company adopted Statement of Financial Accounting Standards
("SFAS") No. 142, "Goodwill and Other Intangibles," which requires that goodwill
no longer be amortized but, instead, tested annually for impairment. There was
no impairment of goodwill in 2003 or 2002. The impairment of goodwill, if any,
would be charged to earnings in the period in which the impairment is
determined. Prior to 2002, goodwill was being amortized on a straight-line basis
over 15 years. Amortization expense was $486,000 for 2001.
Other operating expenses in 2003 decreased $123,000 or 4.4%. Loan and collection
expenses decreased $44,000 for 2003 compared to 2002. Included in other losses
were losses taken on the disposal of fixed assets amounting to $3,000 and
$107,000 for 2003 and 2002, respectively. Other operating expenses in 2002
increased $548,000 or 24.3% compared to 2001, primarily the result of an
increase of $176,000 related to loan and collection expense, other losses taken
upon disposition of equipment totaling $107,000 and an increase of $108,000
related to other outside service expense, such as payroll service expense and
consulting fees.
The overhead ratio, which is computed by subtracting non-interest income from
non-interest expense and dividing by average total assets was 1.46% for 2003
compared to 1.42% for 2002 and 1.79% for 2001.
Income Taxes
Income tax expense for the Company was $2.1 million in 2003, $2.6 million in
2002, and $2.1 million in 2001. The lower tax expense in 2003 reflected the
Company's decrease in before tax earnings in addition to a decrease in
tax-exempt interest income.
The Company's effective tax rate, income tax expense divided by income before
taxes, was 20.6% in 2003 compared with 22.8% in 2002 and 21.7% in 2001. Of the
20.6% effective tax rate for 2003, the federal effective tax rate was 19.0%
while the Wisconsin State effective tax rate was 1.6%.
Future income taxes may be affected by recent 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, even though there has been no intervening change in the
law. The Department has stated that those revocations would be effective
immediately. The Department has also implemented a program for the audit of
Wisconsin financial institutions who have formed and contributed assets to
subsidiaries located in Nevada, and presumably will seek to impose Wisconsin
state income taxes on income from those operations, at least on a going forward
basis.
Although there will likely be challenges to the Department's actions and
interpretations, the Bank's net income would be reduced if the Department would
succeed in those actions. The Bank could also incur costs in the future to
address any action taken against it by the Department.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. A valuation allowance has
been recognized to offset the related deferred tax assets due to the uncertainty
of realizing tax benefits of a portion of loan loss and mortgage servicing
differences.
Income taxes are provided for the tax effects of transactions reported in the
financial statements and consists of taxes currently due plus deferred taxes
related primarily to differences between the basis of the allowance for loan
losses, deferred loan origination fees, deferred compensation, mortgage loan
servicing, market value adjustments of securities, and depreciation for
financial and income tax reporting in accordance with SFAS 109. The deferred tax
27
assets and liabilities represent the future tax return consequences of those
differences, which will either be taxable or deductible when the assets and
liabilities are recovered or settled.
Balance Sheet Analysis
Acquisitions
Effective November 21, 2003, the Bank acquired a branch facility from M&I
Marshall & Ilsley Bank, Milwaukee, WI ("M&I") located in Kewaunee, WI.
Approximately $9.5 million in deposits and $1.0 million in loans were acquired
as a result of the transaction. The purchase transaction did not have a material
impact on the composition of the balance sheet.
Loans
Total loans outstanding grew to $696.0 million at December 31, 2003, a 4.8%
increase from the end of 2002. This follows a 9.7% increase at December 31, 2002
over 2001 year-end.
Table 9 reflects composition (mix) of the loan portfolio at December 31:
TABLE 9: LOAN COMPOSITION
(dollars in thousands)
--------------------------------------------------------------------------
2003 2002 2001
---------------------- ---------------------- ----------------------
Amount % of Total Amount % of Total Amount % of Total
--------- ---------- --------- ---------- --------- ----------
Amount of loans by type
Real estate-mortgage
Commercial $ 387,820 55.7% $ 351,425 52.9% $ 288,385 47.6%
1-4 Family residential
First liens 72,494 10.4 86,161 13.0 96,626 16.0
Junior liens 21,443 3.1 21,789 3.3 24,748 4.1
Home equity 31,763 4.5 25,415 3.8 22,374 3.7
Commercial,financial
and agricultural 91,009 13.1 89,207 13.4 88,649 14.6
Real estate-construction 77,350 11.1 75,688 11.4 67,939 11.2
Installment
Credit cards and related
Plans 2,145 0.3 2,057 0.3 2,145 0.4
Other 12,315 1.8 12,859 1.9 14,745 2.4
Less: deferred fees, net
of costs 349 0.0 316 0.0 324 0.0
--------- ----- --------- ----- --------- -----
Total loans (net of
unearned income) $ 695,990 100.0% $ 664,285 100.0% $ 605,287 100.0%
========= ========= =========
28
2000 1999
---------------------- ----------------------
Amount % of Total Amount % of Total
--------- ---------- --------- ----------
Amount of loans by type
Real estate- mortgage
Commercial $ 251,971 45.4% $ 201,301 45.0%
1-4 Family residential
First liens 109,173 19.7 95,255 21.3
Junior liens 26,513 4.8 23,811 5.3
Home equity 24,464 4.4 18,963 4.3
Commercial,financial
and agricultural 83,897 15.1 66,159 14.8
Real estate-construction 41,524 7.5 26,535 5.9
Installment
Credit cards and related
Plans 2,140 0.4 1,810 0.4
Other 15,785 2.8 13,636 3.1
Less: deferred fees, net
Of costs 360 0.1 451 0.1
--------- ----- --------- -----
Total loans (net of
unearned income) $ 555,107 100.0% $ 447,019 100.0%
========= ===== ========= =====
The commercial, financial, and agricultural loan classification primarily
consists of commercial loans to small businesses. Loans of this type are in a
broad range of industries and include service, retail, wholesale, and
manufacturing concerns. Agricultural loans are made principally to farmers
engaged in dairy, cherry and apple production. Borrowers are primarily
concentrated in Door, Brown, Outagamie, Waupaca, Waushara and Kewaunee Counties,
Wisconsin. With the current level of rates at historic lows and with financial
institutions throughout the market area competitively pricing the loans, growth
slowed in 2003. The origination of commercial and commercial real estate loans
was primarily from the Company's market area in Brown County. Growth in tourism
related business in Door County slowed in 2003 compared to growth experienced in
prior years, the result of a slowdown in the local economy. The credit risk
related to commercial loans made is largely influenced by general economic
conditions, especially those applicable to the Northeast Wisconsin market area,
and the resulting impact on a borrower's operations. These types of loans are
generally higher in risk than residential real estate loans.
Commercial loans and commercial real estate loans (including construction loans)
totaled $556.2 million at year end 2003 and comprised 79.9% of the loan
portfolio compared with 77.7% of the portfolio at the end of 2002. Loans in
these classifications grew $39.9 million or 7.7% during 2003. Loans of this type
are in a broad range of industries. The credit risk related to these types of
loans is greatly influenced by general economic conditions, especially those
applicable to the Northeast Wisconsin market area, and the resulting impact on a
borrower's operations.
Real estate loans (including construction loans) secured by non-residential real
estate properties involve borrower characteristics similar to those for
commercial loans. Because of their similarities, they are combined with
commercial loans for purposes of analysis and discussion.
Management uses an active credit risk management process for commercial loans to
ensure that sound and consistent credit decisions are made. Management attempts
to control credit risk by adhering to detailed underwriting procedures,
performing comprehensive loan administration, and undertaking periodic review of
borrowers' outstanding loans and commitments. Borrower relationships are
formally reviewed periodically during the life of the loan. Further analyses by
customer, industry, and location are performed to monitor trends, financial
performance and concentrations.
The Company's loan portfolio is diversified by types of borrowers and industry
groups within the market areas that it serves. Significant loan concentrations
are considered to exist for a financial entity when such amounts are loans to a
multiple of borrowers engaged in similar activities that cause them to be
similarly impacted by economic or other conditions. The Company has identified
certain industry groups within its market area, including lodging, restaurants,
retail shops, small manufacturing, real estate rental properties and real estate
development. At December 31, 2003, there existed no industry group concentration
in the Company's loans that exceeded 10% of total loans, although tourism
r